What are small-cap stocks?

Small-cap stocks are shares of companies with a relatively small total market value. "Small" is relative: a small cap in a large market can be worth a few billion euros, far more than most private businesses. What defines the segments is market capitalization, the total value of a company's shares:

\text{Market capitalization} = \text{Share price} \times \text{Shares outstanding}

How the size segments are defined

Index providers usually define segments by their share of each market rather than by fixed amounts. MSCI, for example, counts as large caps the companies that make up roughly the top 70% of a market's value, as mid caps the next 15%, and as small caps the next 14% or so.

Broad indices such as the MSCI World cover only large and mid caps, so they contain almost no small caps. A world portfolio built on them holds small caps only if a separate small-cap fund is added.

A simple illustration

A company has 50 million shares trading at €30:

\text{Market capitalization} = 30 \times 50{,}000{,}000 = 1.5 \text{ billion}

That makes it a small cap in most developed markets. The largest companies in the world are worth more than a thousand times as much.

The size premium

Research going back to the early 1980s found that small companies earned higher average returns than large ones over long periods — the size premium, one of the classic factors of factor investing. The usual explanation is compensation for risk: small companies are more vulnerable in recessions, have less access to financing and are harder to trade.

The premium has been unreliable. Over long stretches, including much of the 2010s and the early 2020s, small caps lagged large caps, especially in the United States.

What they add to a portfolio

Diversification away from the largest companies that dominate broad indices.
A different mix of sectors, typically with more industrials and financials and less technology than large-cap indices.
Higher volatility: small caps usually swing more than large caps and fall harder in sell-offs.

Things to keep in mind

Costs: small-cap ETFs usually have somewhat higher running costs and wider bid-ask spreads than broad large-cap ETFs.
Quality varies: small-cap indices contain many companies without profits; some funds filter for profitability.
Size of the tilt: small caps make up only around a seventh of the investable market, so a small-cap fund of 10–15% of an equity portfolio is roughly their neutral weight.

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