One of the many concepts that mutual-fund companies try to drill into our heads is that owning several funds in the Morningstar “style box” is the best way to achieve diversification. By owning large and small companies, as well as the growth and value style — the storyline goes — an investor becomes fully diversified. Not coincidentally, studies have shown that the more funds and investor owns with a provider, the less likely they are to leave and take their money elsewhere.
With that in mind, it’s always wise to question the conventional wisdom regarding the traditional idea of diversification. An example of one such article of faith is that small caps tend to outpace large caps over time. But is this truly the case?
It’s worth looking at, since the superior long-term performance numbers are typically the primary selling point when it comes to small caps. And small caps have indeed bettered their large counterparts over all time periods — but only if you compare the S&P 500 Index and the Russell 2000 Index. Using only those two indices, small caps have indeed outperformed by a wide margin:
With returns like these, small caps are a must-own asset class for younger and more aggressive investors, right? Well, not necessarily. The reality is that index construction is a huge factor in the outperformance of the Russell 2000 relative to the S&P 500, which weights stocks according to their market capitalization — thus providing maximum exposure to companies that face the most pressure from the law of large numbers. Once an equal-weighted index is used, the numbers in fact look very different — so different, in fact, that it dispells the notion of small-caps’ superiority.
This helps demonstrate that once index composition factors are removed from the equation, small caps lose their advantage.
Ideally, there would be an equal-weight small-cap ETF with a long-term track record to make an apples-to-apples comparison. Unfortunately, there is currently only one such active product – Guggenheim Russell 2000 Equal Weight ETF (EWRS) — and it has been open only since December, 2010. Nevertheless, equal weighting doesn’t have the same impact in the small-cap space as it does with large caps. IWM, for instance, holds only 2.6% of its total assets in its top ten holdings, and its largest position is weighted at just 0.3%. SPY, in contrast, has 18.3% in its top ten and its largest holding — Apple (AAPL) — is weighted at 3.2%.
Still, these returns help illustrate that just as the combination of growth and value has provided little diversification benefit over time, so too does the combination of large and small — providing you look past the performance of cap-weighted large-company indices and focus instead on the equal-weighted approach.
Chalk this up as one more piece of evidence that the style-box approach to diversification benefits the fund companies more than it does individual investors.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.