Risk and Volatility in Small Caps
We recently looked at small caps through the lens of historical performance during economic recovery. To complement that analysis, we look at total risk or volatility.
Market volatility did greatly increase last year, as uncertainty about the impact of the pandemic rose, but we have seen it decline rapidly and substantially, as government support worldwide and the vaccine rollout has allowed for a more constructive outlook.
The first chart shows rolling historical volatility for both developed- and emerging-market indexes and their small-cap equivalents. We can see an impact of last year’s increase in volatility, especially in small caps, but it was modest compared to the impact during the 2008 global financial crisis and the recession that followed. For most of the last 20 years, the MSCI World Small Cap Index had a five-year historical volatility (annualized) that was higher than that of the MSCI World Index (on average 2.5%). Volatility for the MSCI Emerging Markets Index remained closer to the volatility of the MSCI Emerging Markets Small Cap Index.
One way of combining the risk and return perspectives is to look at the Sharpe ratio. This ratio shows the average return earned in excess of the risk-free rate per unit of volatility or total risk. The reason to subtract the risk-free rate from the average return is to better isolate the return associated with higher-risk investment decisions. Generally speaking, the greater the value of the Sharpe ratio, the more attractive the risk-adjusted return. If we look at the Sharpe ratio in the second chart, we can see that both of the small-cap indexes would have offered better risk-adjusted returns over the whole period.
Small-Cap Volatility and Risk-Adjusted Returns
Global Investing Trends
Investing globally can help investors work toward global diversification, tap into new opportunities for growth and harness the potential in the rise in importance of emerging markets.Explore More
Revisiting Small Caps
As the world economy starts to feel the benefits of COVID-19 vaccines, some investors have started to revisit the role of small-cap stocks in their portfolios.Read More
Index Performance in Changing Economic Environments
The performance of asset selection based on value descriptors has been pervasive across regions and uniformly across a majority of sectors.Read the Blog