January great for small caps, but institutions not cashing in

Small-cap stocks are about to get a boost from something that historically has been responsible for nearly all outperformance over large-cap rivals: the month of January.

However, most institutional investors will not be able to take advantage of this boost.

The January effect, as it is known, acts as a sort of nitrous oxide injection to the hot rods of small-capitalization stocks: Average returns of U.S. small caps in January from 1927 to 2011 were 2.29%, more than triple that of the next best month, February, at 0.72%.

“Nearly all of the average (outperformance of small-cap stocks) over the period 1927-2011 can be attributed to the January effect (which) has remained a persistent feature” of small-cap performance, according to a recent paper by Norges Bank Investment Management, which manages the assets of the 3.72 trillion Norwegian kroner ($646 billion) Government Pension Fund Global, Oslo.

In his 2011 book, “Expected Returns: An Investor's Guide to Harvesting Market Rewards,” Antti Ilmanen wrote that patterns of over- and underperformance in January “appear surprisingly robust over time,” not just in the small-cap space. “Small-cap stock premia have by and large only been earned during Januaries, while the bond term premium has only been earned outside Januaries,” Mr. Ilmanen wrote. “Most remarkably, the realized credit premium has been positive in January and net negative in other months, and high-volatility stocks have only outperformed in January and underperformed in other months.” Mr. Ilmanen is now a managing director at quantitative manager AQR Capital Management LLC.

But institutional investors won't likely benefit from this January boost, which is most pronounced in small-cap stock returns, because managers don't see the effect as being reliable, and because it doesn't fit with a long-term approach of identifying high-quality companies.

“We don't really think there is a January effect,” said Stephen A. Clark, vice president and head of institutional, North America, at Dimensional Fund Advisors, Austin, Texas.

Dimensional has run small-cap equity strategies since before the effect was identified in the early 1980s. Mutual fund returns data since the early 1980s show small-cap managers don't benefit from a January boost the way small-cap indexes do, suggesting “a lot of the excess return in January is driven by microcap stocks,” which most managers don't invest in because of illiquidity and trading costs among other reasons, Mr. Clark said.

He said trusting the January effect is similar to investing in companies that started with the letter “M,” which had beaten their alphabetical rivals only because of the extreme performance of Microsoft Corp., not of any characteristics of company names.

“The January effect does still exist to some extent (in Europe), although there's been some speculation in the last few years whether it's now being pulled forward to December,” said Nicholas Williams, director and head of small-cap equities at Baring Asset Management, London.

He said short-term trading hedge fund strategies might try to take advantage of the January effect, which he said has been present in seven of the past 10 years in European small-cap stocks. “But for the rest of us, the more long-term investors, we're more interested in finding good idiosyncratic stocks that compound returns over the long term; the January effect is not really a factor that can be played,” he said.

Jacques Friedman, principal and head of global stock selection at AQR in Greenwich, Conn., said he has doubts whether the small-cap premium exists. “January effect or not, I've always called (the size effect) into question,” Mr. Friedman said. “We don't have conviction at AQR that exploiting the size effect in stocks adds alpha to your portfolio.”

This article originally appeared in the November 26, 2012 print issue as, "January great for small caps, but institutions not cashing in".