Part 5 - Size... does matter?! (Small/mid-Cap & Growth ETF)
The series continues Friends,
Reading time: 8-10 minutes
Disclaimer: No investment advice or recommendation, this article is for information purposes only. Before you decide on an ETF, take a closer look at it in terms of positions, sampling, regions, etc. I can't describe everything here as it would go beyond the scope of this article
Part 1 (Definition, Categories & Z-Score and Quality Factor): https://getqu.in/RCSY4a/
Part 2 (Value ETF): https://getqu.in/Nfnhqb/
Part 3 (Low Volatility ETF): https://getqu.in/Ub7KpG/
Part 4 (Momentum ETF): https://getqu.in/CNMgGw/
What are Growth and Small Cap ETF?
Growth ETFs place a special focus on the growth of the company. This growth is usually represented by an increase in earnings per share, price/earnings ratio and sales per share over time. Growth ETFs generally take into account both past and expected future values. In other words, unlike the value premium, the focus is not on stocks that are as undervalued as possible, but on those that are showing strong increases in their profits or sales.
Small cap shares are defined by their market capitalization. This is determined by multiplying the number of shares in a company by the share price. Depending on the resulting value, the shares are classified as small, mid or large cap. These limits change from time to time (even the best-known small-cap index, the Russel 2000, sometimes contains stocks with a market capitalization of around USD 10 billion), but the following general rule still applies:
- Small cap: < USD 2 billion
- Mid Cap: 2- 10 billion USD
- Large Cap: > 10 billion USD
- Mega Cap: > 200 billion USD
Relative classifications are also frequently used due to the rapidly aging boundaries. The Vanguard Mega Cap ETF, for example, is based on the CRSP US Mega Cap Index, which is based on the top 70% of companies with the highest market capitalization in the USA. Growth and small-cap ETFs often have a similar stock selection, as it is easier for smaller companies to show strong growth. For example, if Amazon wants to achieve 10% growth in sales per year, it would have to grow by around USD 60 billion each year (double SAP's total annual sales).
Why invest in small-cap or growth?
I'm going to take the liberty of making an excursion into portfolio theory here, a bit of a number crunching, but it's worth it for the sake of understanding.
The original capital asset pricing model (CAPM) was developed in the 1960s and serves, among other things, to reflect a risk-adjusted expected return on the portfolio.
The expected portfolio return is calculated as follows: Rp = Rf + Beta x (Rm ./. Rf)
Where: Rp = return on portfolio/security, Rf (risk-free interest rate), beta (beta factor of the portfolio/security) and Rm = expected market return
Beta simplified (portfolio volatility divided by overall market volatility), or can be found on equity analysis websites (yahoofinance,..)
Risk-free interest rate = usually government bonds (e.g. 10-year federal bond) or can be obtained from auditors (https://www.dhpg.de/de/newsroom/blog/basiszinssatz)
Example:
Expected return of MunichRe
Beta 5j = 0.85 (less volatile than the overall market)
Risk-free interest rate = 2.5
Expected market return = 7%
Rp = 2.5 % + 0.85x(7%-2.5%)
Rp = 6.33 %
MunichRe's expected return is therefore - as it is less volatile - 6.33% p.a.
In fact, MunichRe's past return over the last 5 years was approx. 13.5% p.a.
This represents a risk-adjusted outperformance (alpha) of almost 7%.
... or to put it another way, the CAPM is perhaps not really suitable for deriving a return expectation here, as only one single factor is included as a risk premium: beta.
The deviation of the market return is established in the CAPM only via the beta and thus via the volatility as the only risk criterion, the so-called > systemic risk <. Dies ist bewusst der Fall, da die – durch Studien gestützte – Annahme getroffen wurde, dass > unsystemic risks < would be diversified away in portfolios, so that only the systemic risk would remain in the overall context. However, the CAPM was often not suitable for explaining market movements, which is why it was developed further.
The Fama-French model / birth of smart beta investing
Eugene Fama and Kenneth French - two names that send a shiver down the spine of every business economist - also recognized the insufficient validity of the CAPM model in explaining returns and extended the model by 2 factors, which made it possible to explain significantly more price movements (90% of the previous 70%). The extension was based on 2 observations:
- Size-Premium: smaller companies tend to achieve higher returns than large companies
- Value premium: companies with a low price-to-book/earnings ratio tend to generate higher returns than companies with a high kbv/kgv.
The CAPM has thus been extended: Rp = Rf + Beta x (Rm ./. Rf) + smb +hml
Smb = small minus big (market capitalization / size premium)
Hml = high minus low (kbv/kgv / value premium)
In addition to the volatility premium, size and value premiums are also integrated in the model. In the MunichRe example, for example, a value premium would have brought the expected return closer to the actual realized return.
There are always discussions as to whether there are other - significant - premiums such as a liquidity premium, e.g. for private equity, with which a higher return is to be priced in as the money is not available.
Working out these "premiums" is the basis of many smart beta investing approaches (quality, dividend & value = value premium, growth and small-cap = size premium, low volatility = volatility/risk premium).
Why should we now invest in small-cap and growth?
Because there is a size premium - historically observed & proven by studies - that allows us to potentially outperform the market. Since growth often goes hand in hand with size, this also applies here, even if a purely growth-based approach has historically not been able to achieve any consistent excess returns, but has repeatedly done so in certain market phases.
Historical size premium
There are various studies on the size premium by the major investment houses:
- VanEck, for example, has highlighted a long-term outperformance of small-caps compared to the world index or even compared to emerging markets. Interesting paper here: https://www.vaneck.com.au/globalassets/home.au/home/vaneck_whitepaper_global-smallcaps_fv3.pdf
- MSCI also confirms this with an observed outperformance of the MSCI World Small Cap Index of 2.69% p.a. compared to the MSCI World Index since 1998. They also see an outperformance especially after reviews. Over an investment period of 15 years, small caps have outperformed large caps in around 9 out of 10 cases, as measured by the respective MSCI indices. (https://www.msci.com/www/blog-posts/small-caps-have-been-a-big/03951176075):
