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Are You Holding Small Stocks? You May Not Get Big Returns

Stocks in this article: RYPNX INVE AVFIX FMER

NEW YORK ( TheStreet ) -- Should you load up on small stocks? Plenty of financial advisers think so. But that could be changing.

The advisers believe in the small-cap premium -- the idea that small stocks should outdo large ones over the long term. That approach has produced sizable rewards. During the past five years, the small stocks of the Russell 2000 benchmark returned 26.6% annually, compared to 23.6% for the large caps of the Russell 1000.

However, a growing number of researchers have begun to question the persistence of the small-cap premium. Analysts note there have been long periods when large stocks outperformed. "I am highly suspicious of the small-cap effect,'" says Tim Loughran, professor of finance at the University of Notre Dame. "Large stocks outperform 50% of the time."

The small-cap effect first gained wide notice in 1981 when Rolf Banz of the University of Chicago published a paper on market returns. Banz argued small stocks had outdone large ones by more than three percentage points annually during the previous five decades.

Many academics endorsed the findings, encouraging mutual fund companies to introduce hundreds of small-cap funds. But almost as soon as Banz announced his discovery, small stocks appeared to lose much of their edge.

From 1978 through 2013, the Russell 2000 returned 12.1% annually, compared to 12% for the Russell 1000. "There is not a lot of evidence that the small-cap effect has had pervasive influence in the last couple decades," says Alex Bryan, a Morningstar analyst.

Some researchers argue that in the decades before the 1980s, small-caps shined because of strong performance from the tiniest stocks, including stocks that traded for less than $1 a share. Because such stocks were hard to trade, they often suffered depressed prices. Investors who bought the bargain-priced stocks tended to obtain outsized returns.

But over the years, transaction costs declined, and it became easier to trade illiquid stocks. As a result, microcaps strengthened and no longer produced such big premiums.

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