Small-cap stocks: Go small or go home?

Correlation of Canadian large-cap stocks with other assets

Canadian small-cap stocks: 0.81
US stocks: 0.72
International stocks: 0.73 
Canadian bonds: 0.44
Canadian short-term bonds: 0.27

Canadian small-cap stocks may provide a relatively limited diversification benefit to an investor holding Canadian large-cap stocks. This is because most Canadian stocks are affected by common risk factors, such as global trade, economic growth and inflation. An investor holding Canadian large-cap stocks, based on this data, achieved a greater diversification benefit from holding US stocks, international stocks or Canadian bonds than from holding Canadian small-cap stocks.

When it comes to diversification, investors may want to consider more than correlation. For large-cap investors who never hold small-cap companies, there is a risk of missing some of the next generation of fast-growing companies, most of which start out small. Small-caps can also react differently to economic conditions. Take interest rates as an example. Compared to large-caps, small-caps tend to be more leveraged and borrow much more through floating-rate debt. As a result, small-caps can be more heavily punished when rates rise, and more heavily rewarded when rates fall — although, whether a rate cut is because of recession or recovery matters a lot. This is one example of the point that small-cap stocks tend to be more sensitive to the business cycle than their large-cap peers.

The theory that small-cap stocks offer an extra return to large-cap stocks was developed by Rolf Banz in 1981, based on US market history.³ Perhaps unsurprisingly, this research followed a period of sharp outperformance for US small-cap stocks in the 1970s. Going back to the 1930s, Banz identified a significant premium for small-cap stocks over large-cap stocks. Unfortunately, this premium has largely not held up since it was discovered, either in the United States or most other developed markets.⁴ For example, over the 40-year period from 1978 to 2018, US small-cap stocks represented by the Russell 2000 index returned 11.1% annualized, versus 11.5% annualized for US large-cap stocks represented by the Russell 1000 index.⁵ And this is just looking at return, without considering the higher volatility of small-cap stocks, which reduces their risk-adjusted performance.

An important exception to the observed lack of a small-cap premium may apply for investors who are shrewd at eliminating "junk" companies from their small-cap selections.⁶ If investors can achieve this — though easier said than done — then the small-cap premium might be alive and well.

Small-cap stocks can move very differently to large-cap stocks over the short term. In Canada, they significantly underperformed in the global financial crisis of 2008 but handily outperformed in the pandemic crash of 2020.⁷ A January effect can also apply to small-cap stocks, where poor performers are oversold in December, partly because of tax-loss selling or because portfolio managers are not keen for investors to see laggards in year-end reports. The stocks that are sold in December have tended to stage a recovery in January.

Significant differences between large-caps and small-caps can extend beyond the short term. Looking at the 10-year period from 2014 to 2023, the annualized return of Canadian large-caps was 8.1% compared to 2.9% for Canadian small-caps.⁸ This decade included a bear market for energy and commodities, which are heavily represented in the Canadian small-cap index. Over the same 10-year period, the annualized return of US large-caps was 12.4% compared to 8.5% for US small-caps.⁹ This decade included a bull market for US technology, which has come to dominate the US large-cap index. Overall, recent evidence from Canada and the United States indicates that small stocks can underperform large stocks for a decade.

¹ Correlation ranges from -1 to +1 and measures the extent to which one stock moves with another. A correlation of -1 means a very strong tendency for one stock to go up and another stock to go down: perfect negative correlation. A correlation of +1 means a very strong tendency for both stocks to move in synch: perfect positive correlation. The lower the correlation between two investments, the greater the diversification benefit to the investor.

² Correlations are based on monthly fund returns over the 10-year period from January 1, 2014 to December 31, 2023. Funds represent broad market indexes: Canadian large-cap stocks, S&P TSX 60 (XIU); Canadian small-cap stocks, S&P TSX Small Cap (XCS); US stocks, S&P 500 (ZSP); international stocks, MSCI EAFE IMI (XEF); Canadian bonds, FTSE Canada Universe Bond (XBB); and Canadian short-term bonds, FTSE Canada Short Term Overall Bond (XSB). US and international stock funds are currency unhedged, which means they are affected by currency values as well as stock values.

³ Source: Rolf W. Banz, The Relationship Between Return and Market Value of Common Stocks, Journal of Financial Economics 9 (1981) 3-18 Opens in a new window..

⁴ The US size premium is missing in action, while the international size premium is also hard to find.

Sources: 

• AQR Capital Management, There Is No Size Effect: Daily Edition Opens in a new window..
• Research Affiliates, Busting the Myth About Size Opens in a new window..

⁵ Source: Rolf Agather, What have you done with my small-cap premium? Published by CFA Institute, June 2019 Opens in a new window..

⁶ Source: Clifford Asness, Andrea Frazzini, Ronen Israel, Tobias J. Moskowitz, Lasse H. Pedersen, Size matters, if you control your junk, Journal of Financial Economics, Volume 129, Issue 3, September 2018 Opens in a new window..

⁷ Fund returns of Canadian small-cap stocks (XCS) and Canadian large-cap stocks (XIU), calendar years 2008 and 2020. Data from Portfolio Visualizer.

⁸ Fund returns of Canadian small-cap stocks (XCS) and Canadian large-cap stocks (XIU), January 1, 2014 to December 31, 2023. Data from Portfolio Visualizer.

⁹ Fund returns of US small-cap stocks (VB) and US large-cap stocks (MGC), January 1, 2014 to December 31, 2023. Data from Portfolio Visualizer. 

¹⁰ Source: Blitz, David and Hanauer, Matthias Xaver, Settling the Size Matter (September 4, 2020). Available at Social Science Research Network (SSRN)Opens in a new window..