My Favorite Way to Play the ‘Small-Cap’ Effect

In a world where “can’t-lose” investment themes regularly disappoint investors, the “small-cap effect” has stood the test of time.

The small-cap effect refers to the long standing market anomaly that small-cap stocks consistently outperform large-cap stocks over the long run. Widely debated among academics and analysts, the “small-cap effect” has found its way into every introductory text on modern finance and investment.

Why Do Small-Cap Stocks Outperform?

Eugene Fama, one of 2013’s Nobel Prize economics winners, and his colleague Ken French, both of the University of Chicago, analyzed the “small-cap” effect in their famous 1992 paper “The Cross-Section of Expected Stock Returns” covering the period 1963-1990.

Their conclusion?

Small-cap stocks were riskier than their large-cap counterparts. But as Modern Portfolio Theory suggests, that higher risk was compensated for by higher returns.

Other analysts have argued that the outperformance of small-cap stocks is due to market inefficiency. After all, small cap stocks aren’t as well covered as household names.

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