3Q17 Factor Alpha Newsletter
Market Cap

Categories Investing, Market Cap, OSAM Research

As widely reported, in the years since the financial crisis of 2008 passive investing has gained in popularity. While passive investing may have merit in certain portfolios, we believe that traditional indexing is flawed. Traditional indexes are designed to capture the performance of the market. As such, the weights of individual securities within the index are weighted by market capitalization. The larger the stock, the greater its weight in the index, implying also the greatest influence on the return of the overall index. In other words, traditional passive investing is a bet on market capitalization as an investment factor.

If you believe in the power of exposure to robust investment factors, as we do, then indexing a portfolio based on market cap is intellectually challenging. In the charts below, we create hypothetical portfolios grouped by market cap, across various universes. Our selection universe for this analysis is equal-weighted. This means that every stock under consideration receives the same weight.

Traditional indexes are designed to capture the performance of the market by weighting individual stocks within the index based on their market capitalization. The larger the stock, the greater its weight in the index, implying also the greatest influence on the return of the overall index. In other words, traditional passive investing can be summed up as “Placing a Bet on Market Cap as an Investment Factor.” While Passive investing may have merit in certain portfolios, we’ve done the work and we strongly believe traditional indexing is flawed.

The intent of this special format Factor AlphaSM Newsletter (FAN) is to follow live-time performance of a single multi-factor Theme (or a ratio, such as Dividend Yield) versus its benchmark — across various universes of stocks. As we’ve done in every FAN to date, before diving into our multi-factor Themes we start by isolating the difference in 3Q17 performance between our Equal-Weighted selection universe versus a benchmark’s Market Cap-Weighted methodology.1 Without further ado:


“Market Cap-Weighted” less “Equal-Weighted”

3Q17 Cumulative Excess Return (7/1/17–9/30/17)


OSAM’s “Microcap” Universe2
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OSAM’s “Small Cap” Universe3
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OSAM’s “Large Cap” Universe4
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OSAM’s “International” Universe5
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OSAM’s “Canadian” Universe6 (CAD)
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  1. For these live-time snapshots, the portfolio is calculated using a compositing methodology: Monthly portfolios are created with a 12-month holding period, then the 12 monthly portfolios are combined to create the composite portfolio.
  2. The Microcap universe can be divided into three broad categories: (1) New Ventures that have become revenue-generating within the past three years, (2) distressed Fallen Angels that have descended into the microcap universe from small cap — and sometimes large cap — and (3) those in a Steady State (microcaps for at least three years).
    From 1982 through 2016, New Ventures represented 25% of the microcap universe, while 16% were Fallen Angels, and 59% were Steady State. Effectively, 41% of the universe is in some sort of transition — ranging from startup to established firm, or from established firm to potential liquidation. When you think about microcap, think of a revolving door where firms are constantly entering and leaving for different reasons.
  3. We refer to Small Cap stocks as the universe including all stocks trading on the NYSE, AMEX, and NASDAQ with an historical inflation-adjusted market capitalization between $200 million and $2 billion.
  4. Large Stocks consists of stocks traded on U.S. exchanges with an inflation-adjusted market cap greater than average.
  5. All the stocks have headquarters and are domiciled outside of the U.S. and Canada.
  6. The benchmark comprises less than 300 names, with the top 10 names accounting for approximately 35 percent of the total market capitalization. The top 50 of the 500 most liquid names within the Canadian market account for approximately 60% of total liquidity (the 50 most liquid names in the U.S. market account for less than 40%).