Microcaps’ Factor Spreads, Structural Biases,
and the Institutional Imperative
(Part 2 of 2)

Categories Author: Ehren Stanhope, Investing, Market Cap

In the first part of this 2-part article, we define microcap stocks and their unique, transitory nature. This second part guides investors through the factor landscape in Micro and explores where investors can expect to find opportunities.

Factor investing is more effective in Micro than in any other cap range

Though factor investing has rooted itself squarely in large cap equities, we believe it significantly more effective in small and microcap — the eclectic corners of the market. In Part 1, we use the quality themes of Financial Strength, Earnings Quality, and Earnings Growth to screen out stocks. Now we turn our focus to a broader suite of multi-factor themes by folding value and momentum in to the portfolio. While value and momentum are also effective in negative screening (which stocks to avoid), they are most effective in identifying which stocks to select.

In an analysis of each multi-factor theme’s performance from 1982 through 2016, we have found enormous differentials in the return spread between high- and low-ranking stocks. Spreads serve as a proxy for how robust a factor is. In the academic literature, these are hypothetical long-short portfolios that suggest the size of a systematic return premium.

The table below shows the spread between the return of high and low deciles in Large, Small, and Micro stocks on each theme. Using this lens, it is readily apparent that factors are more robust in micro than they are in large — or even small — stocks. Within the microcap space, the smallest spread (Earnings Quality: 14.5%) is greater than the largest in Large Stocks (Value: 12.5%). This highlights the importance of quality in microcap once again. As measured by the spread, quality is 3⨉ to 4⨉ more significant in Micro than it is in Large Stocks.

Return Spread — High Decile minus Low Decile
(Annualized, 1982–2016)

The spreads for Value and Momentum in Micro are more than double the Large Stocks spread. The Value spread in Micro suggests one could go long a portfolio of the cheapest stocks and short the most expensive to earn an eye-popping 28.2% annualized return. Practically, this would be virtually impossible due to the operational challenges and costs of managing the short side of a microcap portfolio. This real-world complexity necessitates a focus on generating return by not owning the lowest-ranked names, as opposed to shorting and owning the highest-ranked names.

The table below continues our previous analysis of adjusting the microcap universe for quality by eliminating poorly-ranked names. To that group of stocks, the two rightmost columns display the results from owning only those names falling in the highest-ranked decile by Momentum and Value, respectively.

Incorporating Value & Momentum Alongside Quality
(1982–2016, Compustat)

As with quality adjustments, a focus on momentum improves return by 3.6% annualized with 10% lower volatility than the quality-adjusted group. The addition of Value is even more compelling. A focus on Value improves return by 6.1% annualized with 17% lower volatility than the quality-adjusted group.

Structural features underpin the persistence of factors in Micro

While we wish we were the only ones aware of the massive spreads available in the Micro space, the reality is that this information is well known. In theory, it is curious that investors have not arbitraged this clear edge. In practice, real world implementation costs quickly erode theoretical alpha if not managed precisely. There are three inherent structural constraints to scale that hamper professional money managers, thus, protecting the persistence of alpha for dedicated investors at appropriate scale.

Transactable stock — SUPPLY

Liquidity can be thought of along a spectrum that ranges from the most liquid U.S. Treasury securities (T-bills) to illiquid private businesses (Private Equity). Moving to the illiquid end of the spectrum, the cost of implementation increases, magnifying the importance of expertise when transacting in scale. The primary considerations as it relates to implementation on the liquidity spectrum are free float and dollar volume of transactions.

The Liquidity Continuum


“Float” is the number of shares that are freely available to trade. While a mega cap firm like Apple has a free float of 96% of its shares outstanding, microcap stocks tend to have the lowest free float as a percentage of the total shares of any market cap range. As of year-end 2016, microcap stocks had an average free float of just 72% of shares outstanding. Because of their stage in the business life cycle, microcaps commonly feature large ownership by founders and insiders, and relative to large stocks, could be considered closely held. This feature is important because it reduces by 28% the available supply of microcap stocks in which to transact.1

Transactable stock — VOLUME

Dollar volume gives a sense of transaction velocity, and an investor’s ability to enter and exit the market at will. The chart below details total dollar volumes (adjusted for inflation) for Large, Small, and Micro stocks over the past 20 years. The dollar volume for Large and Small Stocks is 245⨉ and 43⨉ greater, respectively, than microcap. The relatively low $420 million total dollar volume for all microcap stocks suggests that an active manager employing similar strategies to the ones discussed in this article would find it difficult to oversee strategy assets of significant size, while still being able to transact (as of 4/30/17).

Total Dollar Volume by Cap Range ($ bil)
(Inflation-adjusted, logarithmic scale, as of 3/31/17, source: IDC, Compustat)

Transaction costs

While free float and volume constrain the ability to oversee a large amount of assets in the space, implementation costs erode theoretical factor spreads. At scale, these costs can be material. Real world costs have always been, and will likely continue to be, a barrier to entry at scale in less efficient spaces.

Investors must grapple with 3 costs of implementation: commissions, market impact, and bid-ask spreads. Fortunately, commissions have a relatively low impact on cost given the highly competitive nature of the brokerage business. Most institutional transactions occur at pennies per share (generally not relevant unless transacting in penny stocks). Commissions are the only true explicit and measurable cost. The more relevant and hidden share of costs are market impact and bid-ask spreads.

The chart below organizes the U.S. market into liquidity groups sorted from most to least dollar volume to assess the market impact and bid-ask spread of a hypothetical $10 million trade to get exposure to each liquidity group. Overlaid on the chart is the measure of dollar volume across the market. The horizontal axis is the average market cap for each liquidity bucket. From this, one can infer that dollar volume and market cap are highly positively correlated, while cost and dollar volume are clearly inversely correlated. Said another way, the smaller the stock, the lower the dollar volume, the more expensive to trade.

Trade Offs — Cost of $10M Exposure ($ mil)
(As of 3/31/17; ITG, IDC, Compustat)


A $10 million trade could be implemented in the most liquid group of U.S. stocks for approximately 5bps. Sophisticated trading techniques would likely neutralize this impact altogether as smart traders act as liquidity providers when establishing positions. This is made considerably easier with $480 million in average daily dollar volume with which to work the trade. Capacity in this part of the market is virtually unlimited. On the other end of the spectrum, stocks in the least liquid bucket bear an all-in cost estimate of 220bps, a 44⨉ increase in cost on 99.97% lower dollar volume with which to trade. Again, sophisticated trading techniques could minimize, but in this case not eliminate, relevant costs. Capacity in this corner of the market is low, but alpha potential is massive.

Supply, volume, and cost act as significant barriers to scale in microcap. Not only do they require a specialized set of skills to implement portfolios in an efficient manner, they also require money managers to exercise restraint regarding strategy capacity.

Scale destroys alpha; alpha is expensive to realize

Objectively, the capacity of a given strategy is a function of supply, volume, and cost of implementation. Subjectively, and most importantly, capacity is determined by the investment manager’s desire for assets under management. Increasing strategy capacity can often lead to conflicts of interest between the business necessity for fee generation and the client necessity for alpha generation. There is a dichotomy in the fact that less liquid microcap stocks require greater skill in implementation, while also requiring restraint in scale. From a product management perspective, the space is unappealing to large money management organizations because asset-based fees on low capacity strategies struggle to support the costs of dedicated teams.

Micro and small cap managers often creep up the market cap spectrum in order to realize greater capacity. Moving up-market results in smaller factor spreads, and therefore, reduced opportunity for alpha generation. Another alternative is bearing greater market impact costs through larger trade sizes. Both are unappealing options. Static, however, are manager fees, which capture a greater proportion of alpha even as the effectiveness of factors are diluted.

Look Beyond Highly-Competitive Markets for Factor Exposure

We’ve been conditioned for decades to believe that obvious anomalies will be arbitraged away. Most investors readily agree that alpha is scarce. It is hard to find, highly sought after, and requires skill to extract. Based on this premise and the recent horrendous performance of active managers, many investors establish their beachhead in the most competitive portions of the equity market, large cap, where alpha is most scarce.

The Institutional Imperative

Though we often mock the Hollywood scene, we are just as guilty of stargazing. Institutions follow their peers like hawks, and research has shown that “herding” occurs among even the most sophisticated asset allocators.2 For a multi-billion-dollar plan, sheer size alone prevents access to microcap.3 So, instead they pay massive fees for coveted, concentrated access to illiquid private equity markets where their edge cannot be arbitraged away — well, not as easily. Should smaller investors follow suit?

While large allocators face structural constraints, all else equal, this behavior doesn’t make sense for smaller investors. Just as business schools teach the intricacies of the Efficient Market Hypothesis, students cross the courtyard for their next round of classes in …marketing strategy, corporate finance, competitive strategy, game theory, entrepreneurship… all of which are oriented toward identifying and exploiting strategic business advantage. Investors should start building allocations where competition is low and alpha is less scarce: microcap. Why not approach allocations from the non-institutional perspective?

A Different Perspective

At a time when the proliferation of factor investing is being driven by asset gatherers in highly-competitive spaces, astute investors likely find the research on factors in microcap quite enticing. We began by reviewing the Russell definition of microcap and discovered that the majority (88%) of what Russell considers microcap is in fact small cap! The inferior construction methodology of the index — simple market cap-weighting — omits critical considerations for quality and the cost of implementation in microcap. This is important because the lackluster results of index returns fail to offer a compelling narrative for microcap in traditional mean-variance portfolio construction. We then explored the composition of the microcap universe to shed light on why it is a less competitive and lower-quality space. A revolving door of New Ventures and Fallen Angels flank a core group of Steady State firms, which cause significant variability in the measurement of underlying stock fundamentals — often leading investors to write off the space as “a junkyard littered with poor-quality stocks.” We then honed in on pure microcap stocks that offer the potential for risk-adjusted return on par with large stocks through a framework for quality assessment. Significantly greater spreads (from 2⨉ to 3⨉) for the multi-factor stock selection themes of value and momentum in microcap — as compared to large and small stocks — fuel the potential for substantial value-add.

Based on the structural barriers of supply, volume, and implementation costs to scale, we believe a case can easily be made for the persistence of alpha generation in microcap. By breaking away from the institutional paradigm that is heavily-aligned with the most competitive portions of the market, avoiding poor quality, controlling implementation costs, and focusing on stocks with strong momentum and value characteristics, we believe investors can create substantial alpha in this capacity-constrained space.

Return to Part 1.

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  1. Given Apple’s 96% free float, $737 billion of its $767 billion market cap is freely tradeable. Within our microcap universe, just $72 billion of the $100 billion is freely tradeable. This curtails the size of any individual actor in the space, including large institutional investors and product providers.
  2. See William N. Goetzmann and Sharon Oster’s “Competition Among University Endowments” (nber.org/papers/w18173.pdf)
  3. A $5 billion plan would probably need to make a $100 million allocation to microcap to make a difference to overall plan returns. That’s a large allocation to a constrained space. Going larger, a $30 billion plan? Forget about it!