For financial advisers only
Small companies. Big potential. But is buying a broad small-cap index enough to capture the opportunity?
The size premium has long been part of the case for investing in smaller companies: the idea that investors should receive additional compensation for the risks of holding them.
But smaller companies are a varied group. A broad index can hold profitable, established businesses alongside companies with weak earnings and substantial funding needs. Does that distinction matter?
Our latest research paper for financial advisers, From Small-Cap Indexing to Small-Cap Quality and Value, examines the historical evidence and asks whether quality screens or value tilts offer a stronger way to access small-cap exposure.
Download the adviser research paper →
The paper supports a role for smaller companies within a diversified portfolio. Its focus is how that exposure is constructed.
A market-cap-weighted index weights companies according to their market value. A screened or tilted strategy also considers characteristics such as profitability, quality or valuation.
The research examines whether those additional characteristics help explain why some parts of the small-cap universe have historically performed differently from others.
One finding prompted the investment team to investigate further: how much of the historical small-cap premium was concentrated in January.
The team tested the pattern using both academic long-short portfolios and long-only research portfolios, which more closely resemble the exposure investors hold. The paper examines US data and developed markets outside the US, including how the effect has changed over time.
This is a question about the reliability of the underlying size premium, rather than a case for trying to time small-cap investments around the calendar.
Quality considers characteristics such as profitability, financial strength and earnings stability. Value looks at how cheaply a company is priced relative to measures such as its book value.
For its own analysis, Timeline uses operating profitability as a proxy for quality. The paper compares small-cap portfolios with different profitability and valuation characteristics, looking at returns, volatility and falls from previous peaks.
The paper’s argument is that the characteristics of the companies held deserve as much attention as their size.
It also considers examples from index construction and fund management. These provide practical context, although differences between the approaches mean they cannot isolate the effect of profitability or quality alone.
Academic evidence is only part of the assessment. A fund must translate its approach into an investable portfolio, with costs and constraints that research portfolios may not fully reflect.
The paper highlights questions for fund selection: how much small-cap exposure is retained, how quality or value is defined, how far returns may diverge from a conventional index, and whether additional fees and trading costs are justified.
Liquidity and capacity also matter. Quality and value can underperform for extended periods, and historical findings do not guarantee that a particular fund will outperform.
Research for financial advisers
Explore the January analysis, the evidence on profitability and value, practical examples and the considerations that matter when selecting a small-cap fund.
Important information
This blog is prepared exclusively for use by financial advisers and must not be distributed to retail clients. It does not constitute advice, an offer or a solicitation to invest.
Compiled from sources believed to be reliable. Any views, opinions or estimates expressed, including any forecasts or forward-looking statements, constitute the author’s judgement at the time of writing, are not guaranteed and are subject to change without notice. None of Timeline, its directors, officers or employees accepts liability for any loss arising from the use hereof or reliance hereon or for any act or omission by any such person, or makes any representations as to its accuracy and completeness.
Past performance is not a reliable indicator of future results. Academic research portfolios generally exclude transaction costs and market impact and do not represent returns an investor could necessarily achieve. Investments and their income can fall as well as rise, and investors may receive back less than they invested.