Small cap stocks: strategic allocation

October 2021

Small capitalization (a.k.a. “small cap”) stocks refer to the smaller companies in the equity universe by market capitalization. Academic research showed that US small cap stocks outperformed large cap stocks, and as a result, they have become a mainstream asset class for most institutional investors. More recent data shows that the benefits of small cap stock investing have diminished, and there is some debate around the cause of this decline and whether it is a permanent change.

The potential for active managers to generate excess returns (i.e., “alpha”) appears to be higher in small cap stocks than in large cap equities, though the likelihood of active managers generating alpha may also have decreased. Even given the evolution of the small cap stock market, we believe that long-term investors are still likely to benefit by allocating to small cap stocks because of their superior return potential relative to large cap stocks, the higher potential for alpha when using active management, and the modest diversification benefits.