Quant chart: Smaller caps, bigger potential?

When the relative performance is blue, the equal-weighted index is outperforming; when red, the value-weighted index is outperforming. As you can see, historically speaking equal-weighting has generally outperformed value-weighting, supported by research indicating that benefits from size, value, and short-term reversal exposures outweigh the detractions from lower momentum exposure.² While equal-weighting typically delivers positive results, value-weighting significantly outperformed during the dot-com bubble (1994-1999) and from 2011 onwards.

Periods of underperformance for the equal-weighted portfolio often align with challenging times for active managers, who tend to deviate from value-weighted portfolios and are more tilted towards equal-weighted ones.

Skyrocketing valuations versus neglect

So, is this time different? When comparing the two periods of equal-weighted underperformance, we see remarkable parallels. Both periods are characterized by the rise of narratives around disruptive technologies fueling the emergence of new business models, leading to skyrocketing valuations in some market segments while investors neglect others.

Similar to today, equal-weighted portfolios fell out of favor at the end of the 1990s, just before a 10-year run of outperformance. This serves as a potent reminder that investors would do well not to fall prey to recency bias and overemphasize the recent outperformance of value-weighted indices. Historical, long-term evidence suggests that if (or rather, when) this trend reverses, a longer period often sets it, and equal-weighting outperforming value-weighting is more often normal than exceptional.

Small caps coming into their own again

In this context, it’s worth taking a closer look at the relative performance of small caps versus large caps. While we are skeptical about size as a standalone factor, as their higher returns also come with higher risk,³ we observe that the MSCI World Small Cap Index outperformed the MSCI World Index over the last 20+ years (see Figure 2). However, similar to the analysis above, the large-cap index has been difficult to beat in recent years, particularly after 2018.

Figure 2 | Relative performance and valuation of MSCI World Small Cap vs. MSCI World

Source: Robeco, LSEG, MSCI. The figure shows the relative performance and valuation spread of the MSCI World Small Cap Index vs. the MSCI World Index. Performance is measured via the total return index, and the valuation spread is based on four bottom-up-calculated multiples (price-to-book, forward price-to-earnings, price-to-cash EPS, and price-to-dividend). For each multiple, the valuation ratio of the MSCI World Small Cap Index is divided by the same valuation ratio for the MSCI World Index. The sample period is March 2003 to June 2024.

Is the recent underperformance of small caps due to weaker fundamentals or large caps becoming more expensive? Figure 2 illustrates that changes in relative valuations between these segments have significantly impacted their relative performance. Small caps tend to outperform when they become relatively more expensive than large caps, and underperform when they become cheaper.

Therefore, the underperformance of small caps over the last six years has been more a function of changes in relative valuation than of deteriorating fundamentals. In fact, annual valuation changes account for over 70% of the variation in relative performance. The widening gap between performance and valuation suggests that without this disparity, small-cap outperformance would have been much higher over the full period.

Value spread full of opportunities

As of the end of June 2024, the value spread between small and large caps is at levels not seen in over 20 years (see the red dashed line), offering a multi-decade opportunity for investors. Specifically, small caps are trading at a discount of over 20% compared to large caps, based on a composite of valuation ratios (P/B, Fwd P/E, P/C, and 1/DY), while they have traded at a premium of up to 30% in the past.

This large and significant discount is consistent across different valuation ratios and cannot be attributed to differences in sector distributions between small and large caps. Since the valuation ratios also consider the (expected) profitability of different market segments, the argument that a decline in small-cap profitability might explain their underperformance is not supported.

The two graphical insights above highlight that investors should not overemphasize the recent outperformance of mega caps, as history and valuations show that this is more the exception than the rule. It’s worth considering a deviation from market cap weighting and having a more balanced exposure to both small and large caps in your portfolios to capture higher long-term returns.