Small Caps -- No Small Oversight

Many investors recognize that their reference universe should encompass large, mid and small caps, and furthermore accept the investment belief that smaller companies should earn a risk premium over larger ones. Nevertheless, in practice, most of these investors underweight the small cap segment. Institutional investors — particularly in Europe and Asia — tend to have limited small cap representation, even within their own markets. In this paper, we review various aspects of this puzzle and argue that omitting small caps is in fact a significant active decision which many investors may be making unintentionally. An investor with a neutral view on small caps should allocate a percentage weight to small caps that is equivalent to their weight in the full universe. Excluding small caps represents an “active” decision to ignore up to 14% of the universe and amounts to a negative view on the small cap premium. This decision would have forfeited 60 bps of annual performance over the last decade and could have consumed a substantial part of an asset owner's risk budget as well, in the range of 50% to 75%