Small Cap ETFs: The Size Premium Explained by Fama-French
Investors seeking diversification and superior performance are increasingly interested in small caps, notably through passive vehicles like Small Cap ETFs. One of the most popular in Europe is the Lyxor MSCI World Small Cap (ISIN LU1275219762), which offers global exposure to small caps with a competitive TER of 0.35%. This article analyzes the size premium, a key concept in factor investing popularized by Fama and French, and its impact on the performance of Small Cap ETFs, particularly since 2000. We will also put into perspective the specific risks related to this asset class (volatility, liquidity) to formulate allocation recommendations suitable for intermediate French investors.
The Size Premium According to the Fama-French Model
The three-factor model by Fama-French, published in the 1990s, revolutionized the understanding of stock returns by identifying three sources of systematic return: market risk (beta), the value premium, and the size premium. The size premium corresponds to the historical outperformance of small caps relative to large caps, generally attributed to higher risk or lower analyst coverage of small caps.
Historically, the size premium represented an excess return of about +3% per year over several decades, notably in the United States. This outperformance was confirmed by empirical studies covering the period 1927-1999, where small caps delivered an annualized return approximately 3 percentage points higher than large caps, adjusted for market risk.
The Case of Lyxor MSCI World Small Cap (LU1275219762)
The Lyxor MSCI World Small Cap is an ETF that replicates the MSCI World Small Cap index, covering around 14,000 small-cap companies across 23 developed countries. Its TER of 0.35% is attractive for a specialized product, allowing investors easy access to the global size premium.
Feature
Detail
ISIN
LU1275219762
Underlying Index
MSCI World Small Cap
TER
0.35%
Number of Holdings
~14,000
10-Year Annualized Performance (as of 31/05/2024)
+7.5% (before fees)
10-Year Annualized Volatility
~20%
Sharpe Ratio (10 years)
~0.35
Since 2000, the size premium has become less evident in actual performance. The Lyxor MSCI World Small Cap shows a high annualized volatility (~20%), higher than that of large caps (around 15%), and a moderate annualized performance around +7.5% over 10 years, slightly above the MSCI World Large Cap (~7%).
The Apparent Disappearance of the Size Premium Since 2000
Several academic studies and market reports indicate that the size premium has tended to fade or even reverse since the early 2000s. The reasons cited are multiple:
Structural changes: globalization, increased access to information, and the rise of ETFs have reduced inefficiencies in small caps.
Financial crises: the internet bubble 2000-2002, the 2008 financial crisis, and the Covid-19 pandemic severely impacted small caps, which are more sensitive to economic cycles and financing conditions.
Concentration effect: large-cap technology companies massively outperformed, driving the overall performance of large-cap indices.
For example, according to a Morningstar analysis, the size premium measured by the difference in annualized returns between MSCI World Small Cap and MSCI World Large Cap has been negative over the past 20 years, around -0.5% per year, confirming the disappearance of the premium in this recent period.
Volatility and Liquidity: Specific Risks of Small Caps
Small caps are known for their higher volatility and lower liquidity. These characteristics have several implications:
Increased volatility: the annualized volatility of the Lyxor MSCI World Small Cap is about 33% higher than that of large caps, which can lead to significant portfolio fluctuations, especially during stress periods.
Limited liquidity: small caps are less frequently traded, with wider spreads, which can complicate managing inflows/outflows on the ETF, particularly with large volumes.
Impact on portfolio management: these risks justify a cautious allocation and dynamic management, especially for individual investors with shorter investment horizons.
Allocation Recommendations: A Satellite Role in the Portfolio
Given these factors, allocation to Small Cap ETFs like the Lyxor MSCI World Small Cap should be considered a satellite position, complementary to a core portfolio mainly invested in large caps and other factors. General recommendations for an intermediate French investor are:
Moderate allocation: between 10% and 20% maximum of the total portfolio, to benefit from factor diversification without overexposing the portfolio to specific risks.
Long horizon: invest for a minimum duration of 5 to 7 years to smooth volatility and maximize chances of capturing a potential size premium.
Periodic rebalancing: adjust allocation based on market conditions and relative performance of small vs. large caps.
Favor ETFs with low TER: the Lyxor MSCI World Small Cap, with its 0.35% annual fees, is competitive and suitable for global exposure.
Conclusion: The Size Premium, a Factor to Monitor but Not Guaranteed
The size premium, as defined in the Fama-French model, has historically offered an interesting excess return but has faded since the 2000s. The Lyxor MSCI World Small Cap ETF (LU1275219762) provides easy access to this asset class, offering diversified exposure at reasonable fees. However, the high volatility and lower liquidity require prudent management, with a satellite allocation limited to 10-20% of the portfolio.
For intermediate French investors, integrating a Small Cap ETF should fit within a balanced overall strategy aiming to capture factor premiums while controlling risks. The size premium remains a potentially rewarding factor, but its recent behavior underscores the need not to rely on it blindly and to diversify sources of return.
