The Evolution of Small Cap Investing: Four Decades of Innovation at Dimensional

In 1981, Dimensional launched the firm’s first strategy, the US Micro Cap Equity Strategy, pioneering a systematic approach to investing in small capitalisation stocks, also known as small caps.

Over the decades since the launch of the US Micro Cap Equity Strategy, we have broadened our offering of portfolios that invest in small cap stocks, including other single country strategies, regionally diversified solutions and strategies with a stronger focus on small cap value stocks to meet investor needs. Along the way we have also developed deep expertise into what drives expected returns across small stocks and how to capture these returns. Ongoing work from academics and Dimensional’s research and investment teams has contributed to this evolution.

Dimensional Founder David Booth recounts from the firm’s early days the opportunity to invest in an overlooked area of the market: “The motivation for the firm was to develop a new investment strategy based on company size—we called it a ‘small cap fund.’” He notes that at the time, big institutions tended to invest in stocks of large companies, with the only small caps they held generally being stocks that were once large and now had become small. He recollects that “people didn’t even use the term ‘small cap’ back in 1981,” adding, “…with that bit of logic, that’s how we got started.”

From the beginning, Dimensional focused on implementing ideas from academic research in innovative and cost-efficient ways. In 1981, Rolf Banz of the University of Chicago published research pointing to a so-called “size effect.”¹ The research showed that smaller-capitalisation stocks in the US tended to have higher returns than larger-capitalisation names. The challenge was how to capture the returns of smaller-capitalisation stocks without incurring high trading costs in this less liquid part of the market. Dimensional’s approach to managing these costs was the same then as it is today: By using a flexible, daily portfolio management process and steering away from a more rigid approach of closely tracking an index, the US Micro Cap Equity Strategy was not constrained to buy illiquid names at inopportune moments.

Though market mechanics have changed in the past 40 years, our trading philosophy has stayed the same. Exhibit 1 quantifies this benefit in recent years: Compared to an approach that demands immediate execution, Dimensional has been able to buy and sell US small cap stocks at an average pricing advantage of greater than 10 basis points (bps) from 2019 to 2023, with similar outcomes in other developed and emerging markets. Notably, these advantages have helped small and large caps alike and have been even greater in periods of market uncertainty, such as March 2020, adding support for the trading philosophy that first made broad-based small cap investing viable in 1981.

An important development for small cap investing came in the early 1990s with ongoing research on the value premium, which provided evidence for the outperformance of stocks with lower valuation ratios. In 1992, Professors Eugene Fama and Ken French published the three-factor asset pricing model, which improved upon the single-factor Capital Asset Pricing Model and saw the formal addition of both size and value as systematic drivers of differences in expected returns across equities. This produced a sea change in how funds were evaluated—soon it became important for funds to specify which style (value or growth) or size (small, large) they were pursuing.

Dimensional was at the forefront of this evolution. We launched our first two small cap value strategies in the early 1990s—the US Small Cap Value Equity Strategy in 1992 and the World ex US Small Cap Value Equity Strategy in 1995.

As we broadened our offering of small cap and small cap value strategies, a distinct characteristic of Dimensional’s approach continued to be flexibility in what names we bought and sold and when. This flexibility allowed us to consider shorter-term drivers of returns in our daily portfolio management process. One of these was momentum. Studies on price momentum show that, in the short term, stocks with large recent underperformance tend to continue to underperform and stocks with large recent outperformance tend to continue to outperform. As our research on stock price momentum continued through the 1990s and 2000s, Dimensional began to integrate momentum considerations.

Dimensional Portfolio Managers seek to avoid buying names with down momentum and to delay selling names with up momentum. As a result, our small cap strategies are not forced to buy formerly high-flying small stocks as they fall back to earth or to quickly sell stocks that migrate from the small cap market into large caps. Momentum considerations remain integral to our process for managing all equity strategies.

Valuation theory predicts that there should be differences in expected returns across small caps. Advancement in our understanding of the size premium has taught us that small cap stocks with certain characteristics have tended to underperform and failed to deliver the size premium. We believe we can improve the returns of our small cap portfolios by avoiding these while maintaining broad diversification across the small cap market.

One category of small capitalisation stocks with lower expected returns is small growth low profitability firms. Historically, these stocks have had low average returns relative to the broader small cap universe. Dimensional first began excluding small growth low profitability firms in 2010, and the introduction of profitability more broadly into our process in 2013 further refined those exclusions. Today, profitability considerations are incorporated across all strategies that purchase small caps, adding to our focus on small caps with higher expected returns.

Like profitability, firm investment gives additional information on expected returns.² Consistent with valuation theory, firms that must invest heavily to sustain profits should also have lower cash flows to investors than firms with similar profits but lower investment. All else equal, firms with higher investment and, therefore, lower cash flows should have lower expected returns. Fama and French provided early empirical evidence showing the underperformance of firms with high investment, measured using annual asset growth.³ Our research finds that the investment effect is mainly driven by small cap stocks with very high levels of asset growth.⁴ In 2019, Dimensional began to exclude these high-asset-growth names from strategies investing in small caps, adding again to our roster of daily value-adds.

In recent years, a meaningful enhancement to small cap implementation has come from using the information in prices in securities lending markets. When individuals want to borrow shares of stock (for example, to sell a share short), they may borrow those shares from a current shareholder and, in exchange, provide collateral to a lender and pay a fee set by the market. As with stock prices, Dimensional found that securities lending prices also contain information. Particularly, we noted that small cap stocks that were expensive to borrow relative to other small cap stocks tended to have worse performance over shorter horizons. We enhanced our small cap investing process by excluding these stocks from purchase, similar to how we treat down momentum stocks, as shown in Exhibit 2. When choosing between two otherwise eligible names, if a stock is expensive to borrow or exhibiting down momentum, Dimensional has the discretion not to buy these names.

In addition to informing purchase decisions, the securities lending marketplace has also provided Dimensional with opportunities to lend securities and return borrowing fees to investors, helping to offset strategy expenses. Engaging in securities lending is, however, just one way we seek to reduce final costs for small cap investors.

At Dimensional, we are on a continual search for new research and ideas that may lead to advancements in investing. However, we strive not to lose sight of our foundational focus on smart implementation that has benefited investors over time.

Change is a constant, and we expect the evolution of research and client needs to create new opportunities for investment innovation. At Dimensional, we look forward to continuing this tradition of innovation—in small caps and elsewhere.