Portfolio Design: A Modern Approach to Asset Allocation

SUMMARY—KEY FEATURES OF SMALL-CAP STOCKS

Small-cap stocks represent less than 10 percent of the market capitalization of the U.S. stock market. Whether they should be allotted a higher proportion of the strategic portfolio depends on their risk and return characteristics. If one analyzes the Russell indexes for small and large-cap stocks, indexes that begin in 1979, it is difficult to build a case for overweighting small-cap stocks. Whether returns are analyzed using Sharpe ratios or beta and alpha, the results are the same. Small caps do not outperform large caps. The small-cap premium found in the academic literature published in the early 1980s does not seem to exist in the Russell sample period. Only when mid-cap stocks are added to small caps to form the Russell 2500 (or SMID) index is it possible to find a premium for the smaller stocks.

The picture changes significantly if the analysis is extended back through the 1950s. This is true if the SBBI small-cap index is adjusted for risk using standard deviations and Sharpe ratios or using beta and alpha from CAPM. Moreover, the same type of results are found favoring a small-cap premium if the analysis is extended to consider quintiles of stocks above the lowest quintile used in the SBBI small-cap index. For the 59 years beginning in 1951, the small-cap premium is alive and well.

The implications for asset allocation depend on which set of data and period the investor relies on. If the Russell data and the shorter sample period ...