Deconstructing Small Cap & How ESG Scoring Can Mitigate Risk

Osman Akgun, PhD, CFA, Vice President, Domestic Equities


June 30, 2021


Small cap stands for small market capitalization, where a company’s market capitalization is the product of its share price multiplied by the number of outstanding shares. On the size spectrum, small cap is the moniker afforded to companies with a market capitalization of roughly $300 million to $2 billion. These are generally young companies with strong growth potential, but small caps also are typically less stable than their larger, more established peers. While this usually leads to more dramatic short-term price fluctuations and volatility, over longer evaluation periods, there is a greater likelihood that small cap stocks will outperform large caps.


Unfortunately, small cap stocks have a bad reputation

The increased volatility inherent in younger companies—primarily driven by the frequency with which new ventures go bankrupt—means that small cap investors must be willing to accept an increased measure of risk in exchange for higher potential gains.


Yet the risks may be exaggerated. News headlines focus on the negative, from claims of unchecked fraud to an unacceptable standard of corporate operations. The truth is, these are important considerations when investing in a company of any size. And, the relative performance of the Russell 2000 Index as compared to the Russell 1000 Index from 1979 to 6/30/2021 shows that individual small-cap stocks higher growth potential pays off in the long run, as small caps have outperformed large caps over time.(1)


Mitigating risk with an ESG overlay

By and large, Wall Street analysts are skeptics. Such was the reception when socially responsible investing (SRI) introduced the concept of limiting an investable universe to values-based themes over 50 years ago. In the decades since—and as SRI has built a long-term track record—investor interest has grown by leaps and bounds with Wall Street trailing begrudgingly behind. As the lens has broadened from values-based investing alone to include the evaluation of corporate data that shines a light on potential risk control and return benefits, the tide has shifted. Today we see a coalescing of investor interest hand in hand with financial institutions recognizing that returns need not be sacrificed in the pursuit of socially responsible investing.


A fundamental concept of sustainable investing is that firms with better environmental, social, and governance issues (ESG) practices tend to fare better over the long run; think of the investment risks posed by poor corporate governance or climate change. To quote Morningstar, “Funds with higher ESG ratings also bested their benchmarks by larger average margins than funds with lower ESG ratings. In other words, there was a better average payoff to investing in funds that courted less ESG risk.”(2)


Applying ESG to small cap

As one might imagine, ESG factor data has been easier to gather for mid- and large-cap companies than their small brethren. With that, SRI and ESG factor scoring’s early days began with the largest companies (for the largest impact) and has been filtering down the market cap size spectrum since. This historical large cap stock focus has served investors well in the past, but if we return to a period of small cap outperformance, it is time to pointedly shift attention to ESG scoring in the small cap universe.


And, as described earlier, utilizing an ESG framework can help mitigate the risk inherent in smaller companies and has yielded higher investment returns over time.


Understanding ESG score bias

Biased scoring on environmental, social, and governance issues may present a distorted picture for ESG investors, making some stocks appear more attractive or less risky than they actually are. Importantly, there are three main varieties of bias for investors to consider related to ESG scoring: industry bias, country bias, and size bias. For example, there is a well-known bias within the large cap space: larger-sized companies generally have higher ESG scores. That is, bigger companies have greater resources to address and report on ESG concerns and factors.


Yet, this bias is not as strong in the small cap space because the relative size difference of companies in the $300 million to $2 billion range is not as great. Bailard’s research concludes that, unlike with large cap companies, ESG scoring bias within the small cap universe is insignificant.(3) This is good news for ESG investors.


For a deeper dive

This summer, The Journal of Impact & ESG Investing published an important piece from Bailard’s research team that examines one of the three main ESG scoring biases. While we encourage you to visit Bailard’s website for the full investigation, in summary, our research supports the view that investors should feel more confident in ESG scores within the small cap investing space without having to worry about size bias.


 

1 Source: Bloomberg. Russell began tracking the performance of small-cap stocks in 1979. Past performance is not a guarantee of future results.

2 https://www.morningstar.com/articles/1016714/did-esg-pay-off-for-fund-investors-last-year-yes-and-no

3 Akgun, Osman; Mudge, Thomas; Townsend, Blaine. May 2021. “How Company Size Bias in ESG Scores Impacts the Small Cap Investor,” The Journal of Impact and ESG Investing, 1 (4) 31-44.