Do small caps really generate higher returns than large caps?

Ask anyone who entered the stock market in/after 2018 and they will unilaterally tell you that small caps do not generate returns. These are companies which over a period of time will lose market share to their larger counter-parts and perish. Similarly, many other stories go around in the market influenced largely by the dismal performance of small-cap stocks. Nifty small-cap 100 index is down more than 36% from its December 2017 peak whereas the Nifty 100 index comprising of large-cap stocks is up more than 8% in the same period.

But, as is very common in the market, judgment is mostly clouded by near term performance. So, let's see how the Nifty small-cap 100 index has performed over the past 15 years relative to the Nifty 100 index. Figure 1 shows the performance of both the indices over time, when indexed to 100 on 1 January 2005.

In the bull run leading to the global financial crisis in 2008, Nifty Small Cap 100 index far outperformed the Nifty 100 index generating an excess return of over 80%. This excess return since 2005 was however lost in the bear market that followed 2008 and the cumulative returns became in line with the Nifty 100 index.

In the following years until December 2012, both the indices performed in line with slight deviations in both directions. With the deteriorating fiscal condition and state of the economy, in 2013, the small-cap index massively underperformed the large-cap index. By August 2013, the cumulative returns of the small-cap index were 30% lower than the large-cap index.

With the swearing-in of the Modi government, the markets recovered and the cumulative returns of both the indices again fell in line with each other. This was followed by another round of outperformance by the small-cap index in 2017. At its peak in December 2017, the excess cumulative returns of the small-cap index over the large-cap index were greater than 30%.

Such an outperformance paved way for a long and brutal bear market in the small-cap index. In March 2020, the cumulative returns from the Nifty small-cap 100 index were 40% lower than the Nifty 100 index. This magnitude of underperformance by the small-cap index has decreased since then and currently stands at 25%. It is this brutal underperformance that has led to disbelief in small caps as an asset class for investment.

The above analysis over the past 15+ years shows that the Nifty small-cap 100 index outperforms the Nifty 100 index in uptrends and underperforms it in downtrends. Therefore, the pessimism of investing in small caps is overblown and hopefully, we will see a reversion to mean in returns in the future.

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