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Small Caps - No Small Oversight

Many investors recognize that their reference universe should encompass large, mid and small caps, and furthermore accept the investment belief that smaller companies should earn a risk premium over larger ones. Nevertheless, in practice, most of these investors underweight the small cap segment. Institutional investors - particularly in Europe and Asia - tend to have limited small cap representation, even within their own markets.

We review various aspects of this puzzle and argue that omitting small caps is in fact a significant active decision which many investors may be making unintentionally. Excluding small caps represents an active decision to ignore up to 14% of the universe and amounts to a negative view on the small cap premium. This active decision would have forfeited 60 bps of annual performance over the last decade and could have consumed a substantial part of an asset owner’s risk budget as well, in the range of 50% to 75%.

Why do so many institutional investors exclude global small caps in their equity universe? We discuss some of the investment beliefs and perceptions that may underlie this exclusion and also address small cap implementation issues such as free float availability, liquidity, and trading costs.