The tendency of smaller companies to outperform larger companies is perhaps less robust empirically over time than the value factor but also shares a reasonable theoretical underpinning. Namely, small stocks are less liquid (arguably a risk factor in it’s own right – see right column), are followed by fewer analysts, and are individually more volatile so undesirable to own in any meaningful size. Intriguingly, most of the small capitalization effect comes from a relative small subset (roughly 10%) of stocks that perform well enough to become large cap stocks. In other words, letting your winners run can be both tax efficient and empirically sound (see also section on Momentum on our page, Other Factors).
Our strategy to more equally weight our stock holdings for some of our clients (see prior section) leads to some (but likely not by itself adequate) exposure to smaller companies as we tend to avoid outright purchases of small stocks due to their higher trading costs. We will thus often overlay our equity strategies with funds invested in smaller companies and most often when combined with value and quality as the evidence does support that using smaller companies can enhance the expected return potential of those two attributes.