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In Canada, small-cap stocks have failed to live up to the hype

Andrew Hallam is the index investor for Globe Investor's Strategy Lab. Follow his contributions here and view his model portfolio here.

Small cap stock investors have reason to feel disappointed – perhaps even burned. Studies have claimed for years that small stocks outperform the broad market. So when the iShares S&P/TSX Small Cap Index ETF (XCS) was introduced in May, 2007, investors piled in. But the index has crushed them.

If $10,000 were invested at the fund's inception nearly eight years ago, it would have dropped to $9,548 by Feb. 13, 2015. Investors in a plain vanilla Canadian stock index did better. A $10,000 investment in iShares Core S&P 500 S&P/TSX Capped Composite Index (XIC) would be worth about $13,643. That's a gain of 36.4 per cent.

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The iShares U.S. Small Cap Index ETF (XSU) has done much better. In Canadian dollars, since its inception in May, 2007, it gained 42.9 per cent to Feb. 12. But it hasn't delivered on the small cap stock-market-beating promise. An investment in the iShares Core S&P 500 Index ETF (XSP) would have beaten it. During the same time period, it gained 43.9 per cent.

Those with a longer term perspective might scoff at my comparison. Eight years is a long time – in the life of a Golden Retriever. But in the stock market, it's a blip. Stock market historians may point to a longer term study by Nobel laureate Eugene Fama and renowned researcher Kenneth French.

They say that between July, 1926, and February, 2012, U.S. small stocks cumulatively beat large stocks by 253 per cent. Sometimes, large cap stocks beat small caps. Other times, small beats big. Those pegging their hopes on the study by Prof. Fama and Prof. French may need to be patient. By tilting their portfolios toward small cap stocks, the researchers believe investors might beat the market.

But not all researchers agree. In 1999, Tyler Shumway and Vincent Warther published a paper in the Journal of Finance, "The Delisting Bias in CRSP's Nasdaq Data and Its Implications for the Size Effect." (CRSP stands for the the Center for Research in Security Prices.) They believe that small stocks don't beat large stocks at all.

Prof. Shumway and Prof. Warther say small stocks often have shakier financial foundations. During tough economic periods, many get dropped (or delisted) from the stock market. They say that when we measure small cap returns, the data are rose coloured. We only count stocks that survive the storms.

Ted Aronson manages institutional money through AJO Partners. The firm has two small cap funds. AJO Small Cap has averaged 12.4 per cent a year since its 1991 inception. AJO's Small Cap Absolute Value has done even better, averaging 15.8 per cent since it began in 1998. But even Mr. Aronson doesn't believe in the small cap premium. "Small-caps don't outperform over time. … Sure, the long-run numbers show small stocks returning roughly 1.2 percentage points more than large stocks. … [But] the extra trading costs easily eat up the entire extra return – and then some!"

U.S. money manager Ken Fisher of Fisher Investments agrees. He says small stocks usually do well early in a bull market. But they often disappoint when the bull is running on fumes. Over all, Mr. Fisher doesn't believe that small stocks have an advantage over large ones either.

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The firm Research Affiliates is also calling the small cap performance promise a myth. Their researchers dug deeply into the apparent small cap premium to see whether small stocks really outperform. Based on their research, it appears that they don't.

Following the research method of Prof. Fama and Prof. French, they split stocks into two groups for a variety of different countries. The largest 90 per cent were put in one group. The smallest 10 per cent were put in the other. They compared performances for the two groups from 1926 to 2014.

After adjusting for extra transaction costs and delisting bias, Research Affiliates' Vitali Kalesnik and Noah Beck say small stocks don't beat large stocks at all. "If the size premium were discovered today, rather than in the 1980s, it would be challenging to even publish a paper documenting that small stocks outperform large ones."

So should you forget about small cap stocks? That depends. Perhaps they haven't beaten the market. But that doesn't mean they won't.

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