Small-cap stock investors may want to tone down their enthusiasm over the Russell 2000 breaking out. That's because researchers have found that the so-called small-cap effect - the tendency for smaller stocks to outperform larger ones - may not actually exist.

Upon analyzing small-cap returns over the longest period available - back to 1866 - these researchers found that smaller stocks on average do not outperform the market in a statistically significant fashion. Academia's "discovery" of the small-cap effect several decades ago was a fluke of the smaller database that was then available to study.

This result doesn't mean that you should automatically avoid smaller stocks. But it does mean that, when considering investing in smaller stocks, you should select on the basis of other factors besides size.

Consider the performance over the past four years of the Russell 2000 RUT, the most widely used benchmark index for smaller stocks. The index just last week moved above its previous record high set in November 2021.

The research that analyzes small-cap U.S. stocks back to 1866 was reported in a 2021 study, updated in 2023, entitled "The Cross Section of Stock Returns Before CRSP." The "CRSP" in the study's title refers to the "Center for Research in Security Prices" at the University of Chicago. The CRSP database, which is probably the best-known source for U.S. stock-market data, extends back to 1926.

From the beginning of the CRSP database in 1926 through 1990, according to one of the early studies documenting the small-cap effect, smaller-cap stocks did outperform larger ones on a risk-adjusted basis. That's not the final word on the subject, however, since the gold standard in statistical analysis is testing whether the pattern persists out-of-sample. And since the average small-cap stock has not beaten the broad market over the 35 years since 1990, the small-cap effect fails this out-of-sample test.

This pattern could still survive this failure - if it could pass another out-of-sample test covering the period prior to 1926. But according to this study it fails that test too. These failures raise serious doubts about whether the small-cap effect ever really existed.

Even this second failure wouldn't have to be fatal, if there were some theoretical reason why the pre-1926 data should be ignored. But there doesn't appear to be any good reason, according to Edward McQuarrie, a professor emeritus at the Leavey School of Business at Santa Clara University who has spent years studying U.S. stock-market history. In an email, he said that his "understanding is that the University of Chicago team that collected the original data for CRSP in the early 1960s ran out of time and/or money as they got back that far."

How to invest in small stocks

If you still want to invest in smaller stocks, you will need to be choosy. That's according to a 2018 study by several researchers at AQR Capital Management, entitled "Size matters, if you control your junk." They found that smaller stocks are mediocre performers because so many of them are so-called "junk" stocks - losing money, often heavily in debt, for example. They found that the average high-quality small-cap stock performs significantly better.

The researchers considered a stock to be of higher quality if it scored well on a number of dimensions, such as profitability, profit growth, low stock-return risk and a high dividend-payout ratio. With this in mind, I constructed the table below of the Russell 2000 stocks in each dimension's top-quintile that are closest to the quality end of the spectrum. The dozen that made the cut are listed in ascending market-cap order, with the largest five being TXNM Energy (TXNM), New Jersey Resources (NJR), Sabra Health Care REIT $(SBRA)$, DHT Holdings $(DHT)$ and H2O America (HTO).