The benefit of investing in small U.S. stocks is clear. Over the 42-year period from Jan. 1, 1970, to Dec. 31, 2011, a $10,000 investment in large U.S. stocks would have grown to $507,362.

While that sounds impressive, if that same sum had been invested in small U.S. stocks, the value of the portfolio would have been much greater: $693,816. (The performance of large U.S. stocks was measured by the S&P 500, while the performance of small U.S. stocks is represented by the Ibbotson Small Companies Index from 1970 to 1978 and the Russell 2000 from 1979 to 2011.)

Small U.S. stocks outperformed large U.S. stocks during the 1970s as well as during the decade from 2000 to 2009, but large-caps were on top in the 1980s and 1990s. Over this particular 42-year period, the average annualized return of U.S. small stocks was 10.6% compared with 9.8% for large U.S. stocks. As you might expect, however, the standard deviation of return was larger for small stocks than it was for large ones (22.3% vs. 17.8%).

One intriguing measure of performance that's often overlooked is the average three-year rolling return over an extended time frame. Since investors seldom wait 42 years to pass judgment on their investments, three years is a more realistic period for comparing portfolio results.

Over this particular 42-year period, there were 40 three-year rolling return periods. The average three-year rolling return for U.S. small-cap stocks was 11.97% and 10.46% for their U.S. large-cap counterparts. Notice that U.S. small stocks had a higher average three-year rolling return of 151 basis points. In other words, the payoff of small stocks is not just over the long haul. Small-cap U.S. stocks deliver in the short run, too.

It's important to remember, however, that large-cap U.S. stocks and small-cap U.S. stocks are simply two different ingredients in a diversified, multi-asset portfolio. Pitting them against each other is like being asked to pick your favorite internal organ - your heart or your lungs. The issue is not whether large U.S. stocks are better than small U.S. stocks, or vice versa. Rather, the issue is determining their respective contribution to a diversified portfolio.


Using Morningstar Principia as the source of data for this study, there were 412 small-cap U.S. equity funds (mutual funds and exchange-traded funds) in existence as of Dec. 31, 2011. This total included funds in several different categories: small-cap value, small-cap blend, small-cap growth, communications, consumer cyclical, consumer defensive, energy, financial, health care, industrials, natural resources, real estate, technology and utilities. In addition, funds that had more than 5% of their portfolio in bonds, non-U.S. equities or cash were filtered out. And only one share class of a fund was included among those funds that are offered in multiple share classes.

The median market capitalization of these 412 small-cap funds was $1.2 billion, with a maximum value of $2.4 billion and a minimum value of $148 million. The 25 largest small-cap U.S. equity funds (in terms of total assets) represent only 6% of all 412 large-cap U.S. equity funds, but hold nearly 55% of the $262 billion in total assets in small-cap U.S. equity funds.

As of Dec. 31, 2011, the largest 25 small-cap U.S. equity funds held $144 billion in total assets. Of those 25 equity funds, 10 are index-based funds. Those 10 index-based funds held $85 billion in assets, which represented more than half - 59% - of the assets of the largest 25 small-cap U.S. equity funds. Of the five largest small-cap funds, four are index funds.

One small challenge of investing in mutual funds that focus on small-cap stocks is getting into the fund before it closes its doors to new investors. In the universe of 412 small-cap U.S. equity funds, 39 were closed as of Dec. 31, 2011 - accounting for nearly 10% of the funds.


Let's start with a simple two-asset 60/40 portfolio. Portfolio A holds 60% large-cap U.S. stocks and 40% bonds - a classic recipe. Portfolio B is 60% small-cap stocks and 40% bonds. Each portfolio is rebalanced back to a 60/40 allocation at the end of each year.

Over the 42-year period from 1970 through 2011, using small-cap U.S. stocks as the stock ingredient produced better results than using large-cap stocks. Specifically, the average annualized return over the whole period in Portfolio A, with 60% large-cap U.S. stocks, was 9.6%. Portfolio B, with 60% small-cap U.S. stocks, returned 10.3% over the same period.

It's important to note that the small-cap model did have slightly higher volatility as measured by standard deviation (13.9% vs. 11.6%). However, Portfolio B had an ending account value that was 30% higher than Portfolio A.

Next, consider how each of the 25 largest small-cap U.S. equity funds contributed to the performance of a fully diversified 12-asset portfolio over the 10-year period from Jan.  1, 2002, to Dec. 31, 2011. The 12-asset portfolio consisted of equally weighted allocations (8.33%) in the following asset classes: large-cap U.S. equities, mid-cap U.S. equities, small-cap U.S. equities, developed non-U.S. equities, emerging market non-U.S. equities, real estate, natural resources, commodities, U.S. bonds, TIPS, non-U.S. bonds and cash. The performance of each asset class was represented by an established index - with the exception of small-cap U.S. equities.

The annual returns of the largest small-cap U.S. equity funds were inserted into the 12-asset model - one fund at a time - and the 10-year performance of the entire portfolio was calculated as shown in the Portfolio Performance chart on page 92. Only 23 funds were analyzed; the other two lacked a full 10-year history. In general, the 10-year annualized return of a 12-asset portfolio was largely unaffected by which small-cap U.S. fund was used. The most dramatic performance difference was observed when using Allianz NFJ Small Cap Value vs. iShares Russell 2000 Growth Index.

But despite a very large difference in their respective 10-year returns (10.7% vs. 4.4%), the overall portfolio return was only 44 basis points higher with the Allianz fund. This doesn't suggest that differences among individual funds are totally irrelevant, but they are largely irrelevant if you're building a multi-asset portfolio.

The information in this chart illustrates a vitally important point: The asset allocation model is more important than the individual fund being used in the model. As shown, there are a number of perfectly adequate small-cap U.S. equity funds in terms of performance; just pick one of them. The important issue is to build a broadly diversified portfolio - rather than getting hung up on picking the "perfect" small-cap fund.

Craig Israelsen, Ph.D., is an associate professor at Brigham Young University and the author of 7Twelve: A Diversified Investment Portfolio with a Plan.

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