Author Topic: Is a small cap index just obviously superior?  (Read 6236 times)

dragonstache

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Is a small cap index just obviously superior?
« on: March 19, 2014, 09:53:58 AM »
Soooo, I am not sure about my thinking here, so please try and critique me. Just to be clear, I'm talking about small cap, not micro-cap or penny stocks. Legitimate, but small, companies.

A small cap index has all the regular advantages of index funds, low fees, etc. I am aware that they are considerably more volatile on the whole. But as companies grow to a certain size, they exit a small cap index and enter mid-cap range. Is this in effect a way to "buy low sell high"?

Maybe I'm not making myself clear here. Lets say Small Cap Index has companies X, Y, and Z, all currently valued at a market cap of 100M each and purchased at 10 dollars a share. Along with a generally growing market they grow to a size of 120M. All produce capital gains for the fund, but remain in the index because their size is still in the small-cap range. However, Company Z significantly outperforms the market. They are just a great, growing company, offering competitive products and services and a good price, whatever. So they grow to be worth 1Billion, out of the small cap range, and are sold by the small cap index to buy more small companies. In effect, you've bought low sold high.

I guess the opposite could be true of a declining company. Does anyone know if there are any safeguard against this in a passively managed small cap index? Like what if a passively managed small cap index fund had bought shares in Enron just as they were passing down. On the other hand, if a company has a short term valuation (market correction/speculation, whatever) that puts them into the small cap range, a passively managed fund could stand to profit when they swing back up.

It seems to me that another added advantage would be that by buying small cap, you avoid the risk of purchasing into clearly overvalued companies. We can argue about the valuation of Amazon and Facebook all day, but at the end of the day some of the value of these "large cap" companies has to be speculation. Or at least SOME COMPANY that is large cap has to be overvalued. A small cap index, it would seem to me, avoids this.


KingCoin

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Re: Is a small cap index just obviously superior?
« Reply #1 on: March 19, 2014, 10:23:47 AM »
This only makes sense if you believe that stock are mean reverting on a market cap basis (and there's no evidence that I'm aware of that that's true). When the small-cap index sells a now mid-cap stock, you have to believe that that mid-cap stock will subsequently be an under-performer for that to be a profitable trade . You could look at this from a "glass half empty" perspective and say that the small cap index is selling all the companies on the way to major success. Selling out at $200mm market cap for a company on the way to $20bn market cap doesn't seem beneficial. Similarly you could argue that the small cap index is buying all stocks on the way to the corporate graveyard.

As for avoiding "over-valued" companies, I don't see why large cap companies are more likely to be overvalued than small cap companies. In fact, you might argue that the opposite is true. I'm sure you could wade through the small cap index and find plenty of companies whose value proposition is even more dubious than Facebook's.

Are small caps "obviously superior"? No. They're higher return and higher risk on average, so they fit on the efficient investment frontier.

matchewed

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Re: Is a small cap index just obviously superior?
« Reply #2 on: March 19, 2014, 10:29:05 AM »
The coming and going of companies within an index is true for any index though. Nothing makes the small cap superior except for the historical performance of a small cap market which comes hand in hand with the risk you mentioned, volatility.

I view index funds like this. There is a set of criteria I define; all companies with a capitalization between X and Y. I want to make sure I hold the given percentage weights of each so I mirror my criteria. Then I start my index at some arbitrary number I like 100 to start with. In a given day I analyze how much each of my companies moved see how my criteria performed with the weighted average. Now I know it went up 2%. Therefore my new price is 102. As companies move out of my X and Y I do sell the security like you said and look at my criteria.

I don't view this as buying low and selling high because it depends on how the company enters and leaves my criteria. Assume X<Y. It enters from the Y and exits from the Y then it's a buy high sell high situation, enters from the Y and exits the X then it's a buy high sell low, enters from X and exits Y it's a buy low sell high, enters from the X and exits from the X it's a buy low sell low. The hope is that the third scenario is frequent then you will profit from it.

This is just my understanding though, I could be dead wrong.

FrugalSpendthrift

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Re: Is a small cap index just obviously superior?
« Reply #3 on: March 19, 2014, 10:34:20 AM »
Don't confuse size with value.  A small company can certainly be overvalued.  And just because a company grows from a small cap to a large cap, doesn't make them overvalued.


foobar

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Re: Is a small cap index just obviously superior?
« Reply #4 on: March 19, 2014, 02:07:58 PM »
You fund is passively managed. The index on the other hand has active management. Depending on their criteria they may or may not add in stocks.

The fact that companies transition from small to large is a downside of small cap funds. That transition generates a taxable event when the stock moves off the index.

You could say your buying low and selling high when a stock transitions but the other way of thinking about it is that your selling your winners to buy more  of the losers. Who made more money on AAPL. The mid cap who bought in for 3 billion and sold when it hit 10 or the large cap who bought in at 10 billion and road it up to 450 billion?


Small caps have outperformed large caps over the past 100 years but there are periods of underperformance.  Given the huge over performance of the past 15 years, we could be heading towards a period of underperformance.  But no one really knows that.

Soooo, I am not sure about my thinking here, so please try and critique me. Just to be clear, I'm talking about small cap, not micro-cap or penny stocks. Legitimate, but small, companies.

A small cap index has all the regular advantages of index funds, low fees, etc. I am aware that they are considerably more volatile on the whole. But as companies grow to a certain size, they exit a small cap index and enter mid-cap range. Is this in effect a way to "buy low sell high"?

Maybe I'm not making myself clear here. Lets say Small Cap Index has companies X, Y, and Z, all currently valued at a market cap of 100M each and purchased at 10 dollars a share. Along with a generally growing market they grow to a size of 120M. All produce capital gains for the fund, but remain in the index because their size is still in the small-cap range. However, Company Z significantly outperforms the market. They are just a great, growing company, offering competitive products and services and a good price, whatever. So they grow to be worth 1Billion, out of the small cap range, and are sold by the small cap index to buy more small companies. In effect, you've bought low sold high.

I guess the opposite could be true of a declining company. Does anyone know if there are any safeguard against this in a passively managed small cap index? Like what if a passively managed small cap index fund had bought shares in Enron just as they were passing down. On the other hand, if a company has a short term valuation (market correction/speculation, whatever) that puts them into the small cap range, a passively managed fund could stand to profit when they swing back up.

It seems to me that another added advantage would be that by buying small cap, you avoid the risk of purchasing into clearly overvalued companies. We can argue about the valuation of Amazon and Facebook all day, but at the end of the day some of the value of these "large cap" companies has to be speculation. Or at least SOME COMPANY that is large cap has to be overvalued. A small cap index, it would seem to me, avoids this.

kyleaaa

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Re: Is a small cap index just obviously superior?
« Reply #5 on: March 20, 2014, 10:15:00 AM »
Your logic is completely flawed. There is no inherent "buy low sell high" protection with small-cap funds and you don't have any protection against investing in obviously over-valued companies. A company with a $200 million market cap can be just as outrageously over-valued as a $200 billion company.

daverobev

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Re: Is a small cap index just obviously superior?
« Reply #6 on: March 20, 2014, 10:26:08 AM »
Your logic is completely flawed. There is no inherent "buy low sell high" protection with small-cap funds and you don't have any protection against investing in obviously over-valued companies. A company with a $200 million market cap can be just as outrageously over-valued as a $200 billion company.

No, small cap companies do migrate to being larger cap ones; larger cap ones come down for a bit and then go back up. This is, inherently, buying low and selling high.

Compare to a large cap index. If a company is huge, and gets huger... nothing happens.

That's one of the things I like about the FTSE 250 index. Decently sized companies that can go 'up'.

It might not be a plan to pin all your hopes on, but it is a small + point for small/med cap indices.

KingCoin

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Re: Is a small cap index just obviously superior?
« Reply #7 on: March 20, 2014, 10:48:38 AM »
Your logic is completely flawed. There is no inherent "buy low sell high" protection with small-cap funds and you don't have any protection against investing in obviously over-valued companies. A company with a $200 million market cap can be just as outrageously over-valued as a $200 billion company.

No, small cap companies do migrate to being larger cap ones; larger cap ones come down for a bit and then go back up. This is, inherently, buying low and selling high.

Compare to a large cap index. If a company is huge, and gets huger... nothing happens.

That's one of the things I like about the FTSE 250 index. Decently sized companies that can go 'up'.

It might not be a plan to pin all your hopes on, but it is a small + point for small/med cap indices.

But you're buying and selling different companies, so the concept of buying low and selling high doesn't really make sense. When it comes to an individual company, you're buying and selling at the same level. For instance, let's say 200mm is the cut-off for small-cap. When the company's value rises to 200mm, you sell it at 200mm. If it falls back to 200mm, you buy it at 200mm. All the "trades" are being done at the same level.

Initially, you'll own some companies at below 200mm which you'll sell when they get to 200mm (buying low selling high). But you'll also own companies that cross 200mm and fall (buying high and holding low). This is sort of a wash.

foobar

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Re: Is a small cap index just obviously superior?
« Reply #8 on: March 20, 2014, 01:09:00 PM »
Small caps  can also migrate from small cap to micro cap. And from micro cap to nanocap.  That is called buying high and selling low. Do small caps tend to grow faster? Yep. Do they also lose value faster? Yep. A small cap that goes through a decade of mediocre performance like Sears did ceases to exist. A large cap on the other hand takes a long time to die most of the time.




Your logic is completely flawed. There is no inherent "buy low sell high" protection with small-cap funds and you don't have any protection against investing in obviously over-valued companies. A company with a $200 million market cap can be just as outrageously over-valued as a $200 billion company.

No, small cap companies do migrate to being larger cap ones; larger cap ones come down for a bit and then go back up. This is, inherently, buying low and selling high.

Compare to a large cap index. If a company is huge, and gets huger... nothing happens.

That's one of the things I like about the FTSE 250 index. Decently sized companies that can go 'up'.

It might not be a plan to pin all your hopes on, but it is a small + point for small/med cap indices.

daverobev

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Re: Is a small cap index just obviously superior?
« Reply #9 on: March 20, 2014, 01:56:22 PM »
Your logic is completely flawed. There is no inherent "buy low sell high" protection with small-cap funds and you don't have any protection against investing in obviously over-valued companies. A company with a $200 million market cap can be just as outrageously over-valued as a $200 billion company.

No, small cap companies do migrate to being larger cap ones; larger cap ones come down for a bit and then go back up. This is, inherently, buying low and selling high.

Compare to a large cap index. If a company is huge, and gets huger... nothing happens.

That's one of the things I like about the FTSE 250 index. Decently sized companies that can go 'up'.

It might not be a plan to pin all your hopes on, but it is a small + point for small/med cap indices.

But you're buying and selling different companies, so the concept of buying low and selling high doesn't really make sense. When it comes to an individual company, you're buying and selling at the same level. For instance, let's say 200mm is the cut-off for small-cap. When the company's value rises to 200mm, you sell it at 200mm. If it falls back to 200mm, you buy it at 200mm. All the "trades" are being done at the same level.

Initially, you'll own some companies at below 200mm which you'll sell when they get to 200mm (buying low selling high). But you'll also own companies that cross 200mm and fall (buying high and holding low). This is sort of a wash.

Not necessarily; the index doesn't rebalance frequently.

William

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Re: Is a small cap index just obviously superior?
« Reply #10 on: March 20, 2014, 02:45:50 PM »
​U.S. Small-cap value stocks get best return of any mutual fund variety @ 15% average rate of return since 1963...

Not quite enough to make me buy in at 100% of my portfolio though.  I do have a slight lean towards small-caps though.

kyleaaa

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Re: Is a small cap index just obviously superior?
« Reply #11 on: March 20, 2014, 03:00:41 PM »
No, small cap companies do migrate to being larger cap ones; larger cap ones come down for a bit and then go back up. This is, inherently, buying low and selling high.

No, it isn't inherently buying low and selling high. It's true small-cap companies graduate out of the index, but large/mid-cap companies shrink and then disappear. There is no free lunch.

daverobev

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Re: Is a small cap index just obviously superior?
« Reply #12 on: March 20, 2014, 03:07:23 PM »
No, small cap companies do migrate to being larger cap ones; larger cap ones come down for a bit and then go back up. This is, inherently, buying low and selling high.

No, it isn't inherently buying low and selling high. It's true small-cap companies graduate out of the index, but large/mid-cap companies shrink and then disappear. There is no free lunch.

Let me rephrase and clarify.

If a company does well, its share price is likely to follow. Those that do really well go from tiny to small (you buy here; or rather, the index does), and from small to large (you sell here). You have bought low and sold high.

If a large cap company takes a nosedive due to market manipulation or whatever, it would fall into a small cap index, bought low. If it then regains large cap status, it gets sold.

That's all. I'm not saying it helps much, and I know eg Sears will fall and keep on falling, most likely.

daverobev

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Re: Is a small cap index just obviously superior?
« Reply #13 on: March 20, 2014, 03:08:56 PM »
*And* - if small cap has outperformed lately, it is entirely possible it'll underperform for a while, too. No argument there.

foobar

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Re: Is a small cap index just obviously superior?
« Reply #14 on: March 20, 2014, 08:07:26 PM »
If you look at the results in more detail, you will see periods (10-15 years) where one class out performs the other and then it switches. It takes a lot of confidence to get out performed for a decade without switching things up. An other problem is that some of the number are theoretical  and when you add in the added costs and tax burden of strategies some of the difference collapses. And the real kicker is 20 years after this premium was well established, has it gone away? Maybe people chasing returns have bid up  small caps enough to reduce the premium.

That being said I have a strong small cap and value lean in my portfolio....

​U.S. Small-cap value stocks get best return of any mutual fund variety @ 15% average rate of return since 1963...

Not quite enough to make me buy in at 100% of my portfolio though.  I do have a slight lean towards small-caps though.

dragonstache

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Re: Is a small cap index just obviously superior?
« Reply #15 on: March 21, 2014, 01:57:49 PM »
Your logic is completely flawed. There is no inherent "buy low sell high" protection with small-cap funds and you don't have any protection against investing in obviously over-valued companies. A company with a $200 million market cap can be just as outrageously over-valued as a $200 billion company.

No, small cap companies do migrate to being larger cap ones; larger cap ones come down for a bit and then go back up. This is, inherently, buying low and selling high.

Compare to a large cap index. If a company is huge, and gets huger... nothing happens.

That's one of the things I like about the FTSE 250 index. Decently sized companies that can go 'up'.

It might not be a plan to pin all your hopes on, but it is a small + point for small/med cap indices.

This is basically what I meant. That there is an upward limit on the amount valuation (whether justified or not) with small caps that doesn't exist with large caps.

I don't know how to quote multiple quotes, but what foobar said about taxable events (being sold for more) is pretty interesting. Additionally, whoever brought up the point about buying at 200 mm and then selling at 200mm again for a "dipping" company being a wash.

Really interesting responses everyone. Thanks for your input. "Obviously better" may have been more arrogant than I intended; I was actually just looking for some input into my admittedly inexperienced thought process and I got some great responses, so thank you again.