Risk and Volatility in Small Caps

We recently looked at small caps through the lens of historical performance during economic recovery. To complement that analysis, we look at total risk or volatility.

Market volatility did greatly increase last year, as uncertainty about the impact of the pandemic rose, but we have seen it decline rapidly and substantially, as government support worldwide and the vaccine rollout has allowed for a more constructive outlook.

The first chart shows rolling historical volatility for both developed- and emerging-market indexes and their small-cap equivalents. We can see an impact of last year’s increase in volatility, especially in small caps, but it was modest compared to the impact during the 2008 global financial crisis and the recession that followed. For most of the last 20 years, the MSCI World Small Cap Index had a five-year historical volatility (annualized) that was higher than that of the MSCI World Index (on average 2.5%). Volatility for the MSCI Emerging Markets Index remained closer to the volatility of the MSCI Emerging Markets Small Cap Index.

One way of combining the risk and return perspectives is to look at the Sharpe ratio. This ratio shows the average return earned in excess of the risk-free rate per unit of volatility or total risk. The reason to subtract the risk-free rate from the average return is to better isolate the return associated with higher-risk investment decisions. Generally speaking, the greater the value of the Sharpe ratio, the more attractive the risk-adjusted return. If we look at the Sharpe ratio in the second chart, we can see that both of the small-cap indexes would have offered better risk-adjusted returns over the whole period.