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Exploiting the Relative Outperformance of Small-Cap Stocks

by John Davenport and Fred Meissner

Since Rolf W. Banz first posited the size effect of equity returns in a 1981 study published in the Journal of Financial Economics, the relative outperformance of small-capitalization (small-cap) stocks compared to large-capitalization (large-cap) stocks has remained a steady point of debate within the investment management literature.

Even a cursory review of the annualized returns since the inception of the S&P SmallCap 600 index shows that the small-cap index has produced a higher cumulative return than the large-cap S&P 500 index (209.02% versus 188.13%).

The nature of this outperformance has been one of the central points of discussion within the literature. Of primary concern is the variability over time of this outperformance, as discussed in a 1983 Journal of Financial Economics study by Philip Brown, Allan W. Kleidon, and Terry A. Marsh. Sherman Hanna and Peng Chen found that small-cap equities were riskier equity investments relative to large-cap equities for holding periods of less than 15 years, while they were less risky for holding periods of longer than 15 years in their July 1999 AAII Journal article, “Small Stocks vs. Large: It’s How Long You Hold That Counts.”

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John Davenport , Ph.D., is a regional portfolio consultant for Invesco PowerShares Capital Management LLC.
Fred Meissner is president of the Fred Report, which provides financial market research based on technical analysis.


Discussion

Raymond Rimkus from Illinois posted 3 months ago:

Can't wait for the "the separate discussion for another research effort" TIMING OF THE SECTORS" Now we are left hanging here after giving us a taste of what I consider an interesting investment approach Help Thanks


Alice Hunt from Michigan posted 3 months ago:

A timing article would be helpful, I agree. Also, are we to assume that the rotation order is the order from top to bottom of sectors on this chart?


Peter Vaughan from Idaho posted 2 months ago:

How to the small-cap stocks perform when GDP is falling and unemployment rising?


Bruce Stocker from Missouri posted 2 months ago:

Interesting study helps validate my recent (previously puzzling) return experiences.


Ludwig Kuttner from Arizona posted 2 months ago:

It appears that one's risk tolerance no longer needs to extend for the 15 year period described by Hanna and Chen.

The performance of the shadow stock portfolio illustrates that very nicely.

Is there a sector strategy in the selection of that portfolio?


Charles Rotblut from Illinois posted 2 months ago:

Hi Ludgwig,

The criteria we use for the Shadow Stock Portfolio can be found here


Jay Lagree from Delaware posted 2 months ago:

@ Raymond: Lots of info available on sector timing and yield curve. Start with http://www.aaii.com/journal/article/dont-fight-the-fed-interest-rates-and-their-impact-on-the-stock-market

There is even an investment strategy using sector ETF's similar to "Dogs of the Dow". Read about it in Technical Analysis of Stocks and Commodities. Jan 2014 P.36: "Outperform the Market With Sector ETFs".

I have been following the Shadow Stock strategy since 1995. At first I believed it worked because these equities, due to their limitations of size and liquidity, remained under the radar of institutions and day and high frequency traders. These little stocks dwell in the "shadows" waiting for the individual retail investor. Additionally, the strategy is deceptively straightforward and simple.

@Ludwig: Agreed, you don't need to wait 15 years. Recently, a paradigm changing (for me) paper has been published by Ibbotson,et al http://corporate.morningstar.com/ib/html/pdf.htm?../documents/MethodologyDocuments/ResearchPapers/LiquidityAsAnInvestmentStyle.pdf which gives credence as well as understanding to small cap strategies. Although I cannot use SIPro on my Mac, those who still use Windows PCs can easily set up screens for Shadow Stocks with a liquidity kicker.


Aram Tomasian from Massachusetts posted 2 months ago:

from anovice trader dysmall cap fund id better than large cap fund in 2013 . d


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