The curious world of micro caps—faulty benchmarks

I've recently been exploring the world of micro cap stock investing. You don't hear much about this space except from the occasional banner ad promising a 10,000% return in a week by buying penny stocks. So I think micro cap gets a bad wrap. The truth is that you don't hear about micro caps because the large fund and ETF providers generally shy away from the space. At just around $100 billion in total market cap, as opposed to over $20 Trillion for the rest of the market, it truly is a tiny corner of eclectic firms. Liquidity is low and transaction costs are high at scale. These things are anathema to product providers that are constantly seeking the next blockbuster hit ETF that can accommodate tens of billions in assets.

This is the first in a series on micro caps. When I began working at Western Asset in 2008, my then boss had me spend my first week studying the core bond benchmark, the Lehman (now Barclays) Aggregate--how it was constructed, what sectors existed, rules for inclusion, etc. As an active manager, we got paid to beat the benchmark, so understanding our bogey's behavior was critically important. For the first installment, I dive into the Russell Microcap Index to understand it's construction and behavior. The second part will leave the benchmark behind and think more fundamentally about what drives the opportunity set of microcap stocks. The third part in the series will apply some fundamental criteria (factors) to control for the universe's biases to drive (hopefully) outperformance. The final installment is a discussion of the real world application of the theory discussed in the first three installments, and an argument for the persistence of alpha in the space.

Enjoy, comment, send me feedback and questions!


Micro cap stocks represent a fraction of the total U.S. market—literally less than 1% of total capitalization. These stocks are under-covered, unloved, and under-owned. Since the late 1990’s, micro cap’s share of the total U.S. equity market has been cut in half—though it was small to begin with. A key culprit, the proliferation of passive and “Smart Beta” investment products has resulted in disproportionate flows into the large cap space, and therefore, away from small and micro cap stocks. Below is a chart of the share for large (market cap above average) and small (market cap below average) for the U.S. market. Large is dominating. This is the wealth effect in stocks. The big keep getting bigger.

Though there are many unique considerations as it relates to liquidity and tradability at the smaller end of the market, as factor investors who constantly seek ways to tilt the probabilities of investment success the investor’s favor, we simply can’t look away from the opportunity that capacity constrained corners of the market—like micro cap—provide.

What is micro cap?

Russell defines the micro cap space using an ordinal ranking methodology. Whereas the Russell 1000® consists of the 1000 largest stocks in the U.S., the Russell 2000® contains those ranking from 1001 to 3000. The Russell Microcap® Index overlaps with the Russell 2000® in that it includes the 2,001st to 4,000th ranked stock. Russell has conveniently created some overlap to prevent index churn—buying and selling constituents frequently crossing over between index thresholds—because there tends to be a lot of movement in the ranking of stocks at the lower end of the market cap spectrum.

Since these indexes are market cap-weighted, owning the Russell Microcap index is nothing more than owning a small tail of the Russell 2000® plus a minor allocation to even smaller names. 88% of the Russell Microcap® Index overlaps with the Russell 2000®. The correlation of return between the two indexes is 0.96.  (Yet, the relevant iShares Russell ETF (IWC) carries an expense ratio of 0.60%, 3x the fee of its Russell 2000 counterpart (IWD) costing just 0.20%.)

A similar picture emerges when reviewing the share of dollar volume in each index. The table below summarizes the allocation of the total U.S. market based on capitalization and dollar volume across the indexes.

Notice that average dollar volume declines exponentially as you move away from large cap. Also, the small unique portion of the Russell Microcap® index (3,001-4,000), highlighted in green, represents half the dollar volume weight as it does the market cap weight. Low volumes in this corner of the market can lead to significant transaction costs if not managed appropriately. This suggests that the cost of exposure to that small tail is very expensive, and likely a drag on performance of the index. (We'll review implementation costs in the fourth installment of this series.) Based on our own analysis, we found that applying a liquidity floor of $100 thousand-dollar average daily volume, inflation-adjusted, improved the index return by an annualized 0.8% from 1982-2016. That's a huge gain over 35 years.

In current form, the index performance statistics for micro cap certainly do not drive a compelling narrative for adding an allocation to portfolios. The risk-return trade-off is poor enough that commonly used covariance optimization techniques in an institutional asset allocation study would suggest a 0% weighing to micro cap. In fact, most would suggest little or no weight to the small cap Russell 2000® as well. Given these results, its little wonder large cap stocks are all the rage.

In the next post in this micro cap series, I'll diverge from the Russell definition of micro to dive into the composition of micro cap stocks and to why it is widely perceived that micro caps are "junk" stocks.