Now More Than Ever, Size Matters for Stock Returns

Investors can't complain about the performance of the S&P 500 (SNPINDEX: ^GSPC  ) so far this year, with gains of nearly 20% since 2013 began looking especially impressive when you consider that the year still has five months to go. But when you look at some of the other S&P indexes, you'll realize that even with its outsized gains, the large-cap space hasn't given investors everything the stock market has to offer.

Where the best gains are
In fact, when you compare returns across stocks of various sizes, you'll get some surprising results:

  • The SPDR S&P 500 ETF (NYSEMKT: SPY  ) weighs in with 20% gains with its exposure to 500 of the largest companies in the U.S. market.
  • When you step down to mid-cap stocks, though, you'll get even better returns, with the SPDR S&P MidCap 400 ETF (NYSEMKT: MDY  ) posting returns of 21% so far in 2013, based on the performance of 400 mid-sized companies domestically.
  • The smallest companies in the market have done better still, as the SPDR S&P SmallCap 600 ETF (NYSEMKT: SLY  ) has given investors impressive 24% returns since Jan. 1.

Why are smaller companies outperforming the largest stocks in the market? Historically, smaller stocks have posted better long-term returns than their larger counterparts, with theoreticians pointing to the greater risk involved in small-cap stocks as justifying the higher risk premium that investors should demand in order to hold them over the long run.

But there are also a couple of reasons specific to the current environment that have supported small-cap stocks lately. One is that as merger and acquisition activity has risen, small-cap stocks have benefited disproportionately, as large companies tend to be the acquirers in such transactions and end up paying premiums over prevailing share prices in order to buy out their smaller targets. By contrast, small-cap companies that get bought out often exit with a bang, going out in a blaze of soaring-share-price glory.

The other is that the U.S. economy has been relatively healthy compared to those in the rest of the world. Increasingly, large-cap stocks tend to be more exposed to the global economy, collectively getting more of their revenue and profits from overseas and therefore suffering when sluggish conditions abroad hold back their international growth prospects. By contrast, small-cap stocks in the U.S. are often still laser-focused on growing their domestic business, and with U.S. economy conditions continuing to improve, those small caps reap more of the benefit.

What's next?
The flip side of the relationship among different-sized stocks is that during bear-market periods, large caps have often held up better than their smaller counterparts. So if you believe a correction is imminent, banking on continued small-cap outperformance could leave you disappointed. But if you think the bull market has further to run, then small caps might be able to sustain their outperformance and make their more risk-tolerant investors happy for months or even years to come.

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