Each company within the economy of any country has one universal feature: the larger the company, the more difficult it is for it to grow further, outstripping the economy as a whole, because the overall economic field is limited and growing rather slowly. This means that sooner or later every large company is bound to face a certain slowdown in the growth of its business model because it will capture the most accessible part of the market. It will either have to grow towards a less attractive, more complex market space, increasing the costs of growth; or simply stop actively investing the earned profit in their growth and pay most of the money earned to shareholders in the form of dividends. In short: it is easier, on average, for a smaller company to grow than for a larger company.
The effect of smaller capitalization and the American market
Let’s check whether companies with smaller capitalizations actually have slightly better performance per unit of portfolio money we use. Let’s compare ETFs on large and mid-cap indices (Fig. 1): S&P 500 (ETF SPY) and S&P mid-cap 400 (ETF IJH).
In figure 1 we can see not only a higher net return for the investor, taking into account reinvested dividends, but also a higher return per unit of volatility.
Next, let’s compare the indices of large and mid-sized companies starting in the 1970s to make sure that the advantage of smaller caps persists over a longer time horizon (Fig. 2).
As you can see, the advantage of a lower capitalization persists over a longer time interval. Within almost 50 years, we have earned $ 1,000,000 more profit just by changing the ticker.
The effect of smaller capitalization and European markets
In order to be entirely convinced that this premium of lower capitalization exists, let’s go beyond the US market and check the presence of this effect on the European market. We can use the reports of “Morgan Stanley Capital International” or MSCI for short, which have been kept since 1994.
We can see that the yield advantage of >1% has been maintained for several decades. This indicates that the advantage of smaller capitalization cannot be accidental and is a universal property of financial markets.
You can look at MSCI reports of other countries and you will see that this advantage persists in any market.
Building this advantage into our portfolio
Realizing the effect of smaller caps, we will definitely want to integrate it into our XLP + XLU + XLV portfolio from the previous article. In practice, we are faced with the fact that there are no liquid mid-cap ETFs with a long history for the staples, utilities and healthcare sectors. But this limitation is fairly easy to work around, through ETFs of equal-weighted indices RHS, RYU and RYH.
The fact is that classic ETFs consist of a set of companies whose weights are distributed according to the principle “the larger the company, the greater its weight in the ETF”. This leads to the fact that the main part of ETF is shifted towards larger companies, since larger companies are taken by a larger volume, and smaller ones by a smaller volume. However, if we distribute the weight of the companies in equal shares, we will get an ETF in which the volume of smaller capitalizations is the same as the volume of larger capitalizations. In order to partially exploit the advantage of smaller capitalizations, we simply take equal-weighted RSH, RYU, and RYH instead of XLP, XLU, and XLV.
Let’s compare portfolio performance using the eSharpe and CALMAR ratios from the previous article:
XLP + XLU + XLV – 9.05 / 11.32 = 0.79 eSharpe and 9.05 / 33.76 = 0.26 CALMAR
RSH + RYU + RYH – 10.08 / 12.14 = 0.83 eSharpe and 10.08 / 34.77 = 0.29 CALMAR
Adding US treasuries
In one of our previous articles, we discussed adding US treasuries to a portfolio and why it works. Now we will do the same with our new set of tools RSH, RYU, RYH instead of the old set of XLP, XLU, XLV.
We can see an amazing thing: the more profitable portfolio has an even smaller standard deviation (purple box) and a smaller drawdown (blue box) than the less profitable portfolio! This effect is not observed without US treasuries TLT, though. We will look at why this is happening a little later, but in the meantime, we will calculate the portfolio’s performance using the return/risk metrics:
XLP + XLU + XLV – 9.10 / 8.84 = 1.03 eSharpe and 9.1 / 14.03 = 0.65 CALMAR
RSH + RYU + RYH – 9.82 / 8.42 = 1.17 eSharpe and 9.82 / 12.14 = 0.81 CALMAR
Why is our result so much better than we expected? The point is that the slightly larger standard deviation of RSH+RYU+RYH is closer to the standard deviation of the US treasuries TLT stabilizing us. Thus, the slightly higher volatility of RSH+RYU+RYH on 50% of the portfolio works more stably with the second 50% part of the TLT portfolio more effectively compensating each other’s multidirectional fluctuations. For more information, see the screenshot below:
The 12.14% standard deviation of the second portfolio is much closer to the 13.75% standard deviation of the TLT stabilizing instrument than the 11.34% standard deviation of the first portfolio. Therefore, the second more volatile RSH+RYU+RYH portfolio stabilizes TLT better on average. And TLT, in turn, better stabilizes the second portfolio of RSH+RYU+RYH. Due to a more correct mutual weighting by standard deviations, we get a more stable result with fewer risks.
Comparison with SPY
Now let’s compare the performance of our portfolio with the regular S&P500 in terms of risk/return.
RSH + RYU + RYH – 9.82 / 8.42 = 1.16 eSharpe and 9.82 / 12.14 = 0.81 CALMAR
SPY – 8,17 / 15,27 = 0,53 eSharpe and 8,17 / 50,8 = 0,16 CALMAR
We have got a portfolio that exceeds SPY by more than 5 times in the CALMAR metric, while the previous portfolio was 4 times more efficient. The difference is more than noticeable.
The new portfolio has a higher return, lower standard deviation, and lower drawdown. At the same time, we have just changed the tickers and used some primitive mathematics!
Now you know that additional returns can be generated from almost nothing if we understand the correct fundamentals of securities’ returns and apply a little bit of mathematical magic.
In the next article, we will cover the topic of market-neutral calendar spreads on grain markets. Subscribe to our newsletter to quickly learn about the release of new materials.
Good luck in your business and trade! See you in the following articles.