An Empirical Investigation of the Performance of Small

Capitalization and Mid-Capitalization Equity Strategies

Dan diBartolomeo
October 31, 1999

Abstract: This paper reviews the historical performance of US equities classified into
small capitalization and mid-capitalization categories. Returns are reviewed using two
widely published sets of market indices. In addition, a detailed security level simulation
is performed over an eleven-year period. Results are mixed: using one set of index data
gives an economic (but borderline statistically significant) advantage to mid-cap
investing while the other index shows no difference at all. Using an elaborate attribution
model, the simulation tests suggest no overall difference in returns.
Acknowledgement: This paper was underwritten by a grant from INVESCO.

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An Empirical Investigation of the Performance of Small-Cap & Mid-Cap Equity Strategies

Introduction
Investors in the United States have long been aware of the differences between investing
in small capitalization equities and large capitalization equities. Starting in the late
1970s, investors began to widely recognize a third category, middle capitalization
investing. The purpose of this paper is to review the relative performance of small
capitalization and mid-capitalization US equities without any preconceived hypothesis as
to the relative merits of these two approaches.
Within our review we will examine five questions:
1) Have there been any meaningful differences in the historical returns between small-cap
mid-cap investing?
2) To the extent that such differences exist, can they be explained using an appropriate
model of security return behavior?
3) Do the fundamental characteristics of small-cap and mid-cap portfolios differ in ways
other than capitalization, such as P/E multiples, growth rates, etc.?
4) Does either style offer greater promise (or problems) for active management as
opposed to return differences by style that might be captured through index funds?
5) Having a portion of a total portfolio in small-cap equities is often suggested to
investors as a good way to diversify their asset mix. Does shifting between small-cap and
mid-cap styles have any impact on this potential diversification benefit?
Literature Review
There is a very extensive finance literature on the issue of whether capitalization is of
importance to stock returns and other metrics of company performance. The studies that
have been done to date fall into two broad categories: research on the small firm effect
and the others on the size effect. Unfortunately, none of this literature focuses on the
differences between small and middle capitalization stocks.
Much of this research was set into motion by the study of Ibbotson and Sinquefield
(1976) that studied US financial markets from 1926 through 1974. Their results indicated
that average returns on small company stocks were substantially greater than returns on
stocks overall and that this effect was statistically significant. Since this pioneering
study, the same small firm effect has been evidenced in many other equity markets
around the world including Canada, the Netherlands, Australia, Taiwan and Korea.
Once the conclusion that returns on small stocks were larger was widely accepted,
researchers tried to explain the why such a difference existed. Some studies such as Stoll
and Whaley (1983) tried to explain the differences by suggesting that small capitalization

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An Empirical Investigation of the Performance of Small-Cap & Mid-Cap Equity Strategies

stocks had other disadvantages such as high transaction costs. Brown and Barry (1984)
argue that investors have difficulty obtaining detailed information about small firms,
perceive them as riskier due to this uncertainty of information, and hence demand higher
returns. Elfakani and Zaher (1997) suggest that the possibility of insider trading
influences investors to demand more return from small companies.
Research into the size effect generally seeks to prove that there is a linear relationship
between smallness and stock returns. Among the best known of this literature are two
studies by Fama and French (1992, 1995) that find that there is an inverse linear
relationship between capitalization and return. Such a relationship would be consistent
with the Capital Asset Pricing Model (Sharpe, 1964), in that small stocks are generally
believed to have higher systematic risk (beta). However, Fama and French found that the
strength of the relationship between capitalization and return to be much stronger than
would seemingly be predicted by the CAPM. This result suggests that either CAPM beta
is not a wholly effective measure of risk, or that the US equity market is inefficient,
allowing small capitalization investors to earn extra returns without taking commensurate
extra risk.
Berk (1997) attempts to explain the size effect from the perspective of a discounted cash
flow model. If investors value stocks as the discounted present value of future earnings,
the size effect could be the result of investors having different expectations of future
earnings of small companies, or they could be using higher discount rates in computing
the present value. He studied several metrics of firm size, in addition to capitalization,
such as measures of sales, assets and numbers of employees. Only the results for the
market capitalization show any differences in returns between large and small firms.
Berk concludes that investors apply a different discount rate when valuing small stocks.
While the other measures would tend to impact the expectations of future earnings, a
discount rate difference would be evidenced by a direct relationship with firm value.
In the past few years, the validity of the small firm and size effects has been challenged.
The obvious empirical reason is that during the decade of the 1990s, large capitalization
stocks have vastly outperformed small capitalization stocks. This brings into question
whether any of the past studies would still show a meaningful return advantage to small
firms. In addition, many criticisms have been made regarding the methods used in prior
studies. Davis (1996) suggests that the Fama and French results were contaminated by
survivorship bias in the data. Knez and Ready (1997) show that that the Fama and French
studies were very influenced by outliers in the data and that their results are not robust to
removal of such outliers in the data set. The original Ibbotson and Sinquefield study has
often come under attack for its definition of small as the bottom quintile by market
capitalization of the New York Stock Exchange. Such a definition of small means that
the sample contained many large, mature companies that had suffered severe declines in
stock price, as opposed to the young, growing firms that investors often associate with the
concept of small capitalization investing.

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An Empirical Investigation of the Performance of Small-Cap & Mid-Cap Equity Strategies

The diversification benefits of small-cap investing are explored in Grauer and Hakansson
(1986).
Analysis
Frank Russell Company, Wilshire Associates, and Standard and Poors all provide widely
referenced stock market indices for small capitalization and mid-capitalization US
equities. We will begin by analyzing the returns on the Russell and Wilshire indices.
The Frank Russell Company includes the lower two thousand of the three thousand
largest US companies as of each May 31st in its small capitalization index. The midcapitalization index consists of the lower eight hundred of the top one thousand. Wilshire
defines mid-capitalization as the lower seven hundred fifty of the top twelve hundred
fifty capitalizations as each June. Wilshire defines small capitalization to be the lower
seventeen hundred fifty of the top twenty five hundred capitalizations. The return
statistics used in this study are for the Wilshire 250 Small Cap, a portfolio of two hundred
and fifty stocks selected to mimic the returns of the entire seventeen hundred and fifty
member Wilshire small-capitalization universe. It should be noted that the Russell
indices have no common members, while the Wilshire indices are overlapping sets. The
Standard and Poors indices are excluded because they were historically reconstructed
relatively recently and a committee determines membership in the index. Such a
committee procedure may be contaminated by a selection bias toward companies that
have proven successful subsequent to their inclusion in the index.
Our first analysis examines the returns on the Russell and Wilshire indices. All data are
total returns from the S&P Micropal database. Table 1 shows summary statistics for the
Russell indices inception data of January 1, 1979 through September 30, 1999. Table 2
provides the small information for the Wilshire indices from their inception date of July
1, 1980 through September 30, 1999. Table 3 shows the monthly relative returns of each
mid-cap index to its respective small-cap index for their respective sample periods.
Table 1: Russell Index Returns January 1979 through September 1999

Russell 2000/TR
Russell MidCap/TR

Compound
Return
14.46
16.69

StanDev

Skew

Cum %

18.97
16.35

-1.19
-0.87

1549.69
2361.15

Table 2: Wilshire Index Returns July 1980 through September 1999

Wilshire SmallCap250Inx$T
WilshireTargetMidCap750$T

Compound
Return
15.59
15.30

StanDev

Skew

Cum %

17.33
16.67

-1.07
-1.03

1525.33
1450.71

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An Empirical Investigation of the Performance of Small-Cap & Mid-Cap Equity Strategies

Table 3: Monthly Mid Minus Small Relative Returns

Russell Mid Minus Small

Wilshire Mid Minus Small

Monthly
Mean
0.18
-0.03

StanDev T-Statistic
1.85
1.51
0.95
-0.49

The striking, but not surprising, aspect of these numbers is the conflicting story that they
tell. For the Russell indices, there is an economically substantial greater return to the
Russell MidCap index as compared to the Russell 2000. As shown in Table 3, this
difference has a T-statistic making it statistically significant at the 90% confidence level
but not at the 95% level. The Wilshire indices show essentially no difference at all, with
the small-cap index outperforming the mid-cap index by an average of twenty-nine basis
points per year. This difference is not at all statistically significant. We also tried
breaking the sample period into two halves, but neither set of indices showed significant
differences in either period.
Table 4 and Table 5 present annualized returns over rolling (overlapping) periods for the
indices. Again, the Wilshire indices show little difference between mid-capitalization
and small capitalization results. The Russell indices show substantial differences in
returns, with the advantage to mid-cap index for all but the quarterly time periods. The
Russell 2000 actually shows higher annualized mean returns for quarterly periods while
having lower annualized mean returns for annual and longer periods. This apparent
contradiction arises from several causes. Serial correlation, skewness and the greater
volatility of the Russell 2000 all contribute to this oddity. Messmore (1995) and Lo and
MacKinlay (1988) provide explanations of these influences.
Table 4: Annualized Rolling Period Returns for the Russell Indices

Russell 2000/TR

Russell MidCap/TR

High
Mean
Low
High
Mean
Low

Quarter
183.25
24.1
-82.74
191.06
23.31
-76.23

1 Year
97.52
15.8
-27.29
74.6
17.9
-21.45

3 Years
33.93
13.85
-7.55
32.26
16.54
-2.21

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5 Years 10 Years
26.7
16.94
13.28
12.14
2.44
7.65
28.58
18.64
16.15
15.47
8.2
11.88

An Empirical Investigation of the Performance of Small-Cap & Mid-Cap Equity Strategies

Table 5: Annualized Rolling Period Returns for the Wilshire Indices

Wilshire SmallCap250Inx$T

WilshireTargetMidCap750$T

High
Mean
Low
High
Mean
Low

Quarter
191.76
23.32
-76.61
193.42
22.38
-77.26

1 Year
90.73
16.31
-24.17
86.17
16.05
-22.84

3 Years
31.48
15.63
-3.77
30.46
15.53
-2.99

5 Years 10 Years
27.37
17.87
14.91
13.98
5.18
10.77
28.17
17.63
15.1
14.21
6.67
11.34

The first question that we set out to explore was whether historical returns for smallcapitalization and mid-capitalization stocks were different. So far, we have a muddle of
conflicting results.
We now undertake a more detailed investigation of the latter half of our sample period
where there seems to be some discrepancy between the Russell and Wilshire results.
This portion of the study simulates our own small capitalization and mid-capitalization
universe portfolios and attributes their relative performance using Northfields internal
model of US equities for the period January 1989 through September 1999. The details
of the model are presented in Appendix 1.
We begin by creating our own definition of small capitalization and mid-capitalization.
Based on anecdotal discussions with investment professionals, we define small as
stocks with market capitalization below $2 Billion as of September 30, 1999. We define
mid as stocks with capitalization between $2 Billion and $10 Billion as of the same
date. Given the fluctuations in stock market values over the last decade, such fixed dollar
cut-offs might sometimes be inconsistent with investor opinion as to these boundaries.
To provide a consistent definition, we re-specify our size limits in terms of the
standardized logarithm of market capitalization within our database. This insures that
similar fractions of the set of available stocks in our data will be used throughout. We
then constructed historical holdings for two capitalization-weighted portfolios consisting
of the appropriate range of capitalization from all stocks in the Northfield database. The
portfolios began at December 31, 1988 and ended August 31, 1999. Each of the two
portfolios held unchanged throughout the subsequent month. By not having a lower limit
on capitalization, the small-cap portfolio will include a large number of very small
capitalization stocks (micro-cap), but as the portfolios are capitalization weighted, these
tiny companies do not play a large role in either the returns or fundamental characteristics
of the small capitalization portfolio.

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An Empirical Investigation of the Performance of Small-Cap & Mid-Cap Equity Strategies

Table 6: Attribution of Monthly Returns for Portfolios Jan. 1989 to Sept. 1999

Riskfree
SmallCap Systematic Return
Mid versus Small Systematic
MidCap Systematic Return
Factor Policy
Industry Weights
Stock Specific
Mid versus Small Alpha
MidCap Portfolio Return
SmallCap Portfolio Return
MidCap Minus SmallCap Return

Monthly
Average
0.43
0.75
-0.01
0.74
0.06
-0.01
0.04
0.09
1.26
1.17
0.08

StanDev
0.13
4.51
0.46
4.53
1.62
0.28
0.95
1.79
4.02
4.50
1.85

T-Stat Cum Ret

37.57
1.89
-0.25
1.86
0.42
-0.41
0.48
0.57
3.56
2.95
0.49

72.99
128.69
-0.95
127.75
6.04
-1.51
5.51
10.04
351.80
294.74
57.06

Answers to our second question (attribution of the returns) are presented in Table 6.
Overall, the difference in monthly returns was eight basis points (about 100 bp per year)
in favor of the mid-cap portfolio, but was not at all statistically significant. Using the
attribution model to measure returns that could be attributed to differences in portfolio
beta, fundamental characteristics (including market capitalization) and industry weights
did not find any significant effects for any of those variables. The model could not
explain about four basis points of the difference in the mean monthly returns but this
difference is not significant. No aspect of the attribution that looks at the differences
between the small capitalization and mid-capitalization result has any statistical
significance. Like the Russell indices, we find some return advantage to mid-cap
investing over small-cap during the last ten years, but the effect is statistically very weak.
Our third question was whether there are other fundamental differences between the
portfolios other than capitalization. Summary fundamental statistics for the two portfolios
appear in Table 7. On average over the nearly eleven-year sample period, the
fundamental characteristics of the portfolios are quite close. This high degree of
similarity continues at the present time as shown by the information for September 30,
1999. There are some differences in yield, debt/equity ratio and volatility between the
stocks in the two portfolios, but none of these had a meaningful impact on returns as
measured in the attribution. However, it should be noted that using dividend yield plus
earnings growth rate as a simple proxy for expected annual return did give the mid-cap
portfolio an average advantage of about 150 basis points during the sample period. At
the end of the period, there was a very slight advantage to the small capitalization
portfolio.

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An Empirical Investigation of the Performance of Small-Cap & Mid-Cap Equity Strategies

The fourth question of our study is whether either small capitalization or midcapitalization equity investing confers any particular advantages with regard to active
management of portfolios. To examine this issue, we look at the cross-sectional
dispersion of stock returns within each category of stock. Active management is
obviously futile if all stocks within our selection universe provide the same return. The
greater the dispersion, the greater the potential for adding value through active
management, if successful forecasts of individual stock returns can be made. Summary
statistics are shown in Table 8. Using our classification scheme, there were typically
about eight times as many stocks in the small capitalization category as in the midcapitalization category during our sample period. The cross-sectional dispersion of
returns was almost twice within the small-cap universe as within the mid-cap universe.
Grinold (1994) suggest the opportunity to add alpha via active management strategies is
nearly twice as large in such a case. However, this advantage could be wiped out by the
higher transaction costs of the small capitalization stocks. Which effect is more powerful
in practice would depend on the magnitude of the transaction cost difference, the
predictive power of the stock selection model and level of turnover in the portfolio. A
more detailed discussion can be found in diBartolomeo(1998).
Table 7: Monthly Fundamental Characteristics: Average and at Sept. 1999

Factor
Price/Earnings
Price/Book
Dividend Yield %
Trading Activity
Relative Strength
Market Cap
Earnings Variability
EPS Growth Rate %
Price/Revenue
Debt/Equity
Price Volatility
Beta

Average Average
MidCap SmallCap
18.64
18.57
2.24
2.00
2.44
1.82
0.08
0.10
1.06
1.04
4046.09
722.35
0.45
0.48
8.33
7.14
0.93
0.85
0.92
0.72
0.20
0.25
0.98
0.99

9909
9909
MidCap SmallCap
25.31
24.69
2.59
1.99
1.55
1.66
0.11
0.12
1.32
1.17
5321.71
816.59
0.53
0.56
16.14
16.66
1.36
1.37
0.71
0.59
0.31
0.32
1.01
0.99

Table 8: Monthly Average Cross-Sectional Return Dispersion and Sample Size

MidCap
SmallCap

Number of Cross-Sectional
Stocks
Stan Dev
463
8.5
5246
16.1

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An Empirical Investigation of the Performance of Small-Cap & Mid-Cap Equity Strategies

Our final question is that of the diversification benefit. In Table 9, the correlation
coefficients of all four of our published indices with the Standard & Poors 500 stock
index. We also present the information relative to a balanced portfolio of 60% the
Standard and Poors 500 index and 40% the Lehman Aggregate Bond Index (re-balanced
monthly) are presented. We observe a mixed result. For the Russell indices (sample
period January 1979 through September 1999, the Russell 2000 small-cap index was
substantially less correlated with both the S&P 500 and our balanced index than was the
Russell MidCap index. The differences in the correlation coefficients are statistically
significant to the 99% level (three standard-error confidence intervals around each
correlation value do not overlap). The Wilshire SmallCap index (sample period July
1980 through September 1999) was also less correlated with the other asset classes than
was the Wilshire MidCap index, but the differences in the correlation coefficients were
smaller and not statistically significant.
Table 9: Correlation Coefficients (with Standard Errors) to the S&P 500 and a Balanced Index
Correlation to
Correlation to
S&P 500 StanErr Balanced StanErr
Russell 2000
Russell MidCap

0.84
0.94

0.02
0.01

0.79
0.92

0.02
0.01

Wilshire SmallCap
Wilshire MidCap

0.87
0.90

0.02
0.01

0.84
0.87

0.02
0.02

Conclusions
Using data since the inception of the Russell and Wilshire small capitalization and midcapitalization indices, little difference in performance was observable during the first
decade of the sample period. There is evidence that mid-capitalization stocks
outperformed small capitalization stocks during the past decade, but with mixed results as
to the degree of statistical significance. The results are consistent with the index
construction methodologies, which provide greater independence between the
membership sets in the Russell case than in the Wilshire case. A detailed attribution of
the relative returns of sample portfolios found no statistically significant effects in regard
to attributing the observed return differences.
The fundamental characteristics of small-cap and mid-cap portfolios do not appear to be
meaningfully different in ways other than market capitalization. The cross-sectional
dispersion of small-cap stocks is much larger than for mid-cap stocks, but the potential
benefit for active management may be offset by higher transaction costs. Small-cap
investing seems to offer greater diversification benefits than mid-cap, but the results are
inconclusive as to the significance of the difference.

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An Empirical Investigation of the Performance of Small-Cap & Mid-Cap Equity Strategies

References
Barry, Christopher and Stephen Brown. Differential Information and the Small Firm
Effect, Journal of Financial Economics, 1984.
Berk, Jonathan. Does Size Really Matter?, Financial Analysts Journal, 1997.
Davis, James. The Cross-Section of Stock Returns and Survivorship Bias: Evidence
from Delisted Stocks, Quarterly Review of Economics and Finance, 1996.
diBartolomeo, Dan. Everything You Wanted to Know about Alpha but were Afraid to
Ask, Northfield Information Working Paper, 1998, www.northinfo.com.
Elfakhani, Said and Tarek Zaher. Asymmetric Information, Insider Trading and the
Small Firm Effect: An Empirical Investigation, Advances in Investment Analysis and
Portfolio Management, 1997.
Fama, Eugene and Kenneth French. The Cross-Section of Expected Stock Returns,
Journal of Finance, 1992.
Fama, Eugene and Kenneth French. Size and Book to Market Factors in Earnings and
Returns, Journal of Finance, 1995.
Grauer, Robert and Nils Hakansson. A Half Century of Returns on Levered and
Unlevered Portfolios of Stocks, Bonds, and Bills with and Without Small Stocks,
Journal of Business, 1986.
Grinold, Richard. Alpha is IC Times Volatility Times Score, Journal of Portfolio
Management, 1994.
Ibbotson, Roger and Rex Sinquefield. Stocks, Bonds, Bills and Inflation, Journal of
Business, 1976.
Lo, Andrew and A. Craig MacKinlay. Stock Market Prices Do Not Follow a Random
Walk: Evidence from A Simple Specification Test, Review of Financial Studies, 1988.
Knez, Peter and Mark Ready. On the Robustness of Size and Book to Market in CrossSectional Regressions, Journal of Finance, 1997.
Messmore, Tom.Variance Drain, Journal of Portfolio Management, 1995.
Stoll, Hans and Robert Whaley. Transaction Costs and the Small Firm Effect, Journal
of Financial Economics, 1983.

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An Empirical Investigation of the Performance of Small-Cap & Mid-Cap Equity Strategies

Sharpe, William. Capital Asset Prices: A Theory of Market Equilibrium Under Risk,
Journal of Finance, 1964.

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An Empirical Investigation of the Performance of Small-Cap & Mid-Cap Equity Strategies

Appendix I
Description of Fundamental Model
The Fundamental Factor Model is a multiple factor model used to explain the covariance among
US stock returns. In this model, it is assumed that beta can explain some but not all of the
structure of the covariances. For a detailed derivation, see Rosenberg and Guy (FAJ, 1976).
There are sixty- seven factors (items of commonality). The sixty-seven factors consist of beta,
eleven fundamental company characteristics, and fifty-five industry groups. The model can be
written as:
Rit = Rft + it (Rmt - Rft ) +

k = 1 to 66

(Eikt * kt ) + eit

(1)

Rit = return on stock i during period t

it = estimated beta of stock at time t
Rmt = return on the market (our reference universe) during period t
Rft = risk free rate of return during period t (three month Treasury bill)
Eikt = exposure of stock i to factor k at time t
-exposures are standardized values of continuous variables such as yield
-dummy variables for industry membership
kt = Jensens alpha associated with factor k during period t
eit = error term associated with stock i during period t
Essentially, it is nothing more than a standard CAPM with an effort made to sub-divide the alpha
term into 66 components. To the extent we can associate portions of alpha to common factors we
increase the ability of the model to explain covariance, unlike the simple CAPM, which assumes
that beta alone explains all covariance among securities.
The model is estimated each month in two steps. In the first step, we get preliminary estimates
for the beta values (it ) for each stock. To get the it values, we first run a traditional CAPM time
series (60 months) regression of stock is return against the market to get Bi.
Rit = Rft + Bi * (Rmt - Rft ) + it

(2)

Bi = preliminary estimate of beta on stock i

it = error term for stock i during period t under traditional CAPM assumptions
To account for the tendency of beta to shift toward one over time, we adopt the method of Blume
(JOF, June 1975).
Bi* = K + Bi * C

(2a)

K, C = constants
To improve the quality of fit of the model (eit < it ), we can allow the beta values for each stock to
vary over time. For example, it can be observed that highly levered companies have higher beta
values. We could then imagine that a company that has just taken on a great deal of debt to

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An Empirical Investigation of the Performance of Small-Cap & Mid-Cap Equity Strategies

finance an acquisition would have its beta increase. To capture the changes in beta values over
time for a given company, we start by using a cross-sectional regression to estimate the
relationships between beta values and company characteristics across the universe.
Bi* =

k = 1 to 66

Eikt * kt + it

(3)

kt = sensitivity of beta values with respect to differences from stock to stock in

exposure to fundamental characteristic k at time t
it = error term for the beta of stock i at time t
We assume then that the kt values that are derived from an analysis across the universe of
companies can then be applied to a single company as its characteristics change through time.
Once we have the kt values, we estimate the contemporaneous value for it .
it =

k = 1 to 66

Eikt * kt

(4)

Incidentally, this rather complicated procedure for getting a beta has one additional benefit. We
can get a reasonable estimate of beta for a stock with no return history, such as an initial public
offering. Even though it has no return history, fundamental characteristics such as P/E, yield, and
industry are immediately observable and equation (4) can still be used.
Once the beta values are estimated, we can substitute the it values into the equation (1) above
and run a cross-sectional regression to estimate the kt values. The observations in all crosssectional regressions are weighted by square root of market capitalization. This weighting
compensates for the skewness in the distribution of market capitalization. If the observations are
equally weighted, the analysis is biased toward small capitalization names that are far more
numerous. If the observations are capitalization weighted, the effective number of observations
gets far too small for the large number of independent variables.
In this analysis, the return on the market (Rm) is the return on a reference universe of all US
stocks with more than $250 million market capitalization. This return computation is weighted
by square root of market capitalization.
The standardized fundamental variables used as factors in the model are:
Earnings/Price
Book/Price
Dividend Yield
Average Daily Volume/Shares Outstanding
52 Week Relative Strength
Log of Market Capitalization
EPS Variability
EPS Growth Rate (blend of 5 Year historic and IBES Long Term Expected)
Revenue/Price
Debt/Equity
Price Volatility ((52 Week High 52 Week Low) / (52 Week High + 52 Week Low))

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An Empirical Investigation of the Performance of Small-Cap & Mid-Cap Equity Strategies

For the purpose of historic performance attribution, the usage of the model is simple.
Since the factor exposures of each stock in portfolio sum to the factor exposures of the
portfolio, equation (1) also holds for portfolios. Once all items in equation (1) have been
estimated at the stock level we can calculate the beta and factor exposures for a given
portfolio and immediately observe which bets paid off and which did not during a
particular period.

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