Fortunately for investors in the smallest stocks, the last two months of this year may not be as depressing as they usually are.
I’m referring to the historical tendency for small- and large-cap stocks to carve out opposite return trajectories at year’s end. The smallest stocks tend to turn in their best returns in January, and their returns thereafter deteriorate—with that deterioration picking up steam at year’s end. In contrast, the largest stocks tend to be weakest in January and strongest at year end.
These opposite trajectories are quite stark, as you can see from the accompanying pattern. Since 1926, the 10% of stocks with the smallest market caps have experienced a 3.2-percentage-point diminution of average monthly return from the first to the fourth calendar quarters. The 10% of stocks with the largest market caps, in contrast, experienced a 0.5-percentage-point improvement.
Credit for first documenting this pattern, as far as I can tell, goes to Lucy Ackert, a professor of economics, finance and quantitative analysis at Kennesaw State University, and George Athanassakos, a professor of finance at the University of Western Ontario. In a paper published in 2000 in the Journal of Business Finance & Accounting, they attribute the pattern to gamesmanship: As year-end approaches, institutional investors who are ahead of the market have an incentive to make their portfolios increasingly look like the S&P 500 (.SPX) to lock in their relative year-to-date returns—and to eventually earn bragging rights for beating the market for the full year and possibly earn a hefty year-end bonus.
So these managers will sell their small-cap holdings as the end of the year nears, and replace them with the large-cap stocks that dominate indexes such as the S&P 500.
The reason this year may be at least a partial exception: These gamesmanship incentives appear to be weaker in years in which the stock market’s returns through October are—like this year—particularly strong. That is because, Prof. Ackert speculates in an interview, managers are under less pressure to “beat the market” in years in which they nevertheless have produced strong gains. So they will be less likely to dump their small-caps to own the large-cap stocks in the S&P 500.
In contrast, she says, managers during bear-market years are especially eager to make sure they can tell their clients that, even though they may have lost money, they still outperformed a broad market index fund. In the latter part of such years, they therefore would be more likely to dump their smallest stocks in favor of the large-cap stocks that dominate the S&P 500.
The implication for investors is to keep your smallest stocks through the end of this year. That is not just because they are less likely to suffer from their usual year-end doldrums. It’s also because it is crucial to be invested in small-cap stocks in January, and those who get out now often fail to get back in on time.
The reason it is so important to be invested in small-cap stocks during January is that it is far and away the best month of the year for the smallest stocks, regardless of whether the previous year was particularly good or bad for the overall stock market. Since 1926, according to the Fama-French database, the 10% of stocks with the smallest market caps have produced an average January gain of 7.3%—equivalent to over 100% annualized. For the other 11 months of the calendar, their average annualized gain is less than for the average largest-cap stock.
That is a stunning statistic, because it means that there is no small-cap advantage, on average, from February through December.
Note carefully that the smallest stocks that exhibit this pattern in the Fama-French database are extremely small, often referred to as microcap to distinguish them from the stocks that Wall Street considers to be small-cap but which are more appropriately considered midcap. The average market cap of the smallest stock decile, for example, currently is just over $100 million. The average market cap of stocks in the largest-cap decile, in contrast, is $121 billion—nearly 1,200 times larger.
The microcap exchange-traded fund with the most assets under management is iShares Micro-Cap ETF (IWC), with an expense ratio of 0.52%, or $52 annually per $10,000 invested.
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