Author Details

Naoya Nishimura

Naoya Nishimura

Executive Director, MSCI Research

Social Sharing

Extended Viewer

Including Microcaps in Benchmark Indexes: Japan vs. US

  • Investment products based on indexes that exclude microcap stocks would have sacrificed some of the low-size return premium witnessed in Japan and the U.S. during our study period.
  • On the other hand, when microcap stocks were added to a broader hypothetical benchmark, investability of a total-market index would have deteriorated.
  • A comprehensive analysis of the trade-off between market representation and exposure to the size and liquidity factors may help investors seeking to strike a balance.

Institutional investors often face the challenge of seeking to balance comprehensive market coverage and investability when selecting an equity benchmark.1

Exhaustive market coverage may mean including stocks with the smallest market capitalization, i.e., microcap stocks. While microcap stocks tend to have low liquidity and investment capacity — and excluding them may improve portfolio investability — investors could lose opportunities to capture the low-size premium if these stocks are excluded.2


Examining the Trade-Offs

In this study, we examined these trade-offs in terms of including microcaps in investable equity universes in Japan and the U.S., two of the major sources of these stocks.3 We used the MSCI Investable Market Index (IMI) and the MSCI All Cap Index as proxies for the investable universe and total-market universe, respectively.4

We found the trade-off between the low-size premium and liquidity was more significant in Japan, but it was interesting to see that considering liquidity and size together actually improved investability. We inferred this as the MSCI Japan IMI, which takes into account a stock’s traded value per market capitalization for liquidity screening, had a better liquidity and tradability profile than hypothetical indexes with the same number of constituents selected solely on size.


Losing Low-Size Exposure

How much exposure to the low-size factor would the index have lost if microcap stocks were excluded, and how would that have affected low-size-factor return contribution?

For starters, low-size-factor returns in these markets were mainly positive over the past 20-plus years, based on MSCI equity models for Japan and the U.S. The size of the premium, however, trended smaller in the more recent periods.


Annualized Cumulative Low-Size-Factor Return (%) in Japan and the US

  Past 5Y Past 10Y Past 20Y Since Inception
Japan  -0.1 0.8 2.5 4.5
US 0.4 0.1 1.0 1.6

Data as of Feb. 26, 2021, based on MSCI’s Barra Japan Equity Model (JPE4) and Barra US Total Market Equity Model for Long-Term Investors (USSLOW). Model inception dates of JPE4 and USSLOW are Dec. 28, 1984, and June 30, 1995, respectively. Low-size-factor return is defined as -1 multiplied by the cumulative size-factor return of the respective model. By definition, a stock with higher market capitalization is assigned higher size-factor exposure than a stock with lower market capitalization.

We constructed hypothetical free-float-adjusted market-capitalization-weighted indexes for Japan and the U.S. by choosing a fixed number of stocks from the corresponding MSCI All Cap Index constituents (our total-market proxy) by descending order of their market capitalization. We then measured how exposures to the low-size factor changed as the number of constituents increased.

As shown in the exhibit below, exposures to the low-size factor increased as indexes included more stocks with smaller market capitalization. And the convex shape of the curve suggests that adding microcap stocks to an investable universe had a smaller impact on low-size exposure than expanding coverage to smaller stocks found in the investable universe.

We can quantify how the difference in low-size exposure might affect performance by multiplying active low-size-factor exposure by the expected low-size-factor return. For example, using low-size-factor returns from Nov. 30, 2007,5 to Feb. 26, 2021, as the expected low-size-factor return, we estimated the difference in low-size-factor return contribution between the investable and total-market universe to be 12.5 basis points (bps) and 1.9 bps per year in Japan and the U.S., respectively.6 The contribution was much smaller when we looked at the last five- and 10-year returns.


Low-Size-Factor Exposures and the Number of Stocks in Japan and the US

Data as of Feb. 26, 2021. “Largest n Stocks” means hypothetical indexes that include top n securities of the MSCI All Cap Index constituents by descending order of full market capitalization and weighted by free-float-adjusted market capitalization.


More Microcaps Meant Less Liquidity

To assess the effect of microcaps on index liquidity, we look at how many illiquid securities were included in the indexes by our method of choosing stocks from largest to smallest in the total-market universe.7

In Japan, the number of illiquid stocks steadily increased as the universe expanded beyond the investable universe, as shown in the exhibit below — the total-market universe included more than 200 illiquid stocks.8 The number was smaller in the U.S.


The Number of Illiquid Securities in Japan and the US

Data as of Feb. 26, 2021. “Largest n Stocks” means hypothetical indexes that include top n securities of the MSCI All Cap Index constituents by descending order of full market capitalization and weighted by free-float-adjusted market capitalization.

Given that the liquidity of an index is deeply connected to its tradability, we also analyzed the effect of including smaller stocks on tradability, based on the “days to trade” measure of MSCI IndexMetrics,® assuming fund size of USD 10 billion and a daily trading limit set at 20% of daily liquidity.


Days to Trade from Cash in Japan and the US

Data as of Feb. 26, 2021. “Largest n Stocks” means hypothetical indexes that include top n securities of the MSCI All Cap Index constituents by descending order of full market capitalization and weighted by free-float-adjusted market capitalization.

The days it took to complete construction of a free-float-adjusted market-capitalization-weighted index from cash jumped when we began to include stocks with low liquidity relative to their size, and liquidity and tradability issues were more pronounced in Japan than the U.S.


Measuring the Gain vs. the Pain

Assessing the trade-offs involved when selecting an equity benchmark that does or does not include microcap stocks comes down to more than one issue. It involves comprehensive views regarding risk characteristics and liquidity. As we quantified the trade-offs of including microcap stocks into indexes, we found that incorporating liquidity measures, such as those used in MSCI’s GIMI methodology, resulted in a better liquidity profile than choosing stocks based on size alone.



1For example, the Japan Exchange Group recently proposed eliminating certain constituents of the Tokyo Stock Price Index (TOPIX) that fail to meet a certain size threshold, in response to institutional investors’ concerns about investability. For more details, see: ”Index Consultation on Revisions of TOPIX and Other Indices.” JPX, Dec. 25, 2020.

2Some researchers proposed a liquidity premium as an additional source of microcap returns. We investigated this based on liquidity-factor returns of MSCI’s Barra Equity Models, but found little evidence in Japan and the U.S. for the analysis periods in this study.

3As of Feb. 26, 2021, stocks from the U.S. and Japan accounted for 50.3% of weight and 48.6% of the number of constituents of the MSCI World Micro Cap Index.

4MSCI Global Investable Market Indexes (GIMI) cover all investable large-, mid- and small-cap securities across the developed, emerging and frontier markets, targeting approximately 99% of each market’s free-float-adjusted market capitalization. MSCI All Cap Indexes are constructed by aggregating MSCI GIMI and the MSCI Micro Cap Indexes. The microcap size segment is constructed by including all securities that are not part of the GIMI and meet special requirements. For more details, see MSCI Global Investable Market Indexes Methodology.

5Inception date of the MSCI All Cap Indexes.

6The estimation universes of JPE4 as well as USSLOW do not include all microcap stocks in the MSCI All Cap Indexes of respective markets; therefore, factor returns might not fully reflect characteristics of microcap stocks. To complement this issue, we compared historical gross total returns of the MSCI IMI and MSCI All Cap Indexes of both markets. From Nov. 30, 2007, to Feb. 26, 2021, the MSCI Japan IMI Index underperformed the MSCI Japan All Cap Index by 17 bps (JPY basis) per year, to which the JPE4 size factor contributed -8 bps. During the same period, the MSCI USA IMI underperformed the MSCI USA All Cap IMI by 0.3 bps (USD basis) per year, to which the USSLOW size factor contributed -2bps.

7Based on the developed-market minimum-liquidity requirement of MSCI’s GIMI methodology.

8Illiquid securities here are defined as having average traded-value ratio (ATVR) of less than 20%. ATVR is MSCI’s liquidity measure, which shows the percentage of securities’ free-float-adjusted market capitalization traded per year.



Further Reading

Best practices for Japanese equity indexes

Micro Caps - A Distinct Segment

One Size Does Not Fit All: Understanding Factor Investing

MSCI IndexMetrics:® An Analytical Framework for Factor, ESG and Thematic Investing