(December 16, 2013) — Investors considering buying small cap stocks should do so in the next fortnight to achieve the best returns for the following year, according to data from State Street Global Advisors (SSgA).
Studying annualised returns from the past 90 years in the US, Marc Reinganum, senior managing director and quantitative strategist at SSgA, found that the end of the calendar year was the best time to invest in small cap stocks to achieve the highest returns.
Consistently over the 90-year period, small cap stocks’ performance in January dwarfed that of large cap stocks. They also did well in February when compared with large cap stocks—indeed, the first quarter showed outperformance from small caps when compared with large cap stocks.
This “January effect” was most pronounced in the period between 1960 and 1979, when small caps outperformed large caps by more than 1100 basis points. Even during the weakest January effect period—found between 1940 and 1959—the small market caps outperformed their larger peers by 675 basis points on average.
The trend was also evident in Europe. Reinganum assessed data from the MSCI Europe large and small cap indices between January 2000 and September 2013 and found small caps again outperformed large caps across the board.
The largest differential between the two groups’ returns was in January 2000, when small caps outperformed large caps by 900 basis points. Reinganum noted there was perhaps an extra incentive to invest in European small caps, as European equities are forecast to do well in 2014.
Many other economists have noticed this trend. Arthur Hill of the ChartWatchers blog, highlighted this week that the Russell 2000, an index for US small caps, was up almost 3% in the last four weeks compared with a 1.9% increase on the S&P 100.
As to what drives this phenomenon, Reinganum has a few theses. “One theory is that it’s because of individuals’ tax-loss selling,” he said.
“Small caps are more likely to be held by individuals, and for many December marks the end of their tax year. There could be tax incentives for disposing of stocks that have recently made some losses. We know that behaviourally, these investors tend to realise their losses at the end of the year.”
Reinganum also cited mutual funds’ “window dressing” by dropping underperforming small cap stocks in December, which led to a depression in small cap stocks.
Thirdly, the end of the calendar year represents a period of information uncertainty, as many companies put out fewer statements of public information in the run up to their annual statements. This uncertainty can lead to price depressions, Reinganum said.
On the potential impact of future policy decisions, such as rising interest rates, Reinganum said he felt a rising rates market wouldn’t adversely affect small caps compared to large cap stocks.
“While I cannot comment about all potential policy changes and their impact, early this year we did a study on the impacts of rising interest rates on the relative performance of small cap versus large cap companies,” he said,
“From 1979-2012, the evidence clearly suggested that in a rising interest environment, small cap stocks outperformed large cap stocks on average and this relationship held in two-thirds of the occasions in which we measured rising rates.”
In addition, aiCIO asked for data on the performance of small cap stocks during the taper tantrum period of May and June 2013, when stocks, commodities, and bonds all fell. During this period, small cap stocks outperformed large cap stocks by about 250 basis points in the US and by about 210 basis point in Europe.
“For most of our clients, we are not recommending a position that tries to arbitrage the returns between small cap and large cap stocks,” Reinganum said. “However, for clients that intend to allocate to small cap stocks because of their longer term return and risk profiles, history suggests that the next several months represent a particularly opportune entry point.”
Not everyone is convinced by the January effect however. Hamish Galpin, head of small and mid-sized caps at Hermes Fund Managers, told aiCIO that while he often saw some of the better quality stocks sold off at the end of the year in favour of more “racy stocks”, the performance of the better quality ones tended to be recovered within three to four months, prompting many investors to return.
On the impact of rate rises on the sector, Galpin said he was not overly concerned about whether an interest rate increase could result in a number of small cap zombie companies collapsing—a name given to companies which are only surviving thanks to the low rate environment—adding there was likely to be more zombies hiding in the large cap sector.
“Small caps are still pretty big corporations, and generally they’ve restructured effectively since the start of the financial crisis,” Galpin said. “Looking at MSCI indices and the gearing figures, you can see that large caps are more highly geared than small caps.
“Although there will definitely be pockets of gearing in the sector, it’s likely to be in the usual suspects, such as property and pub companies. An active manager will be able to avoid these.”