Small-cap stocks have historically outperformed large- and mid-cap stocks, especially after recessions and over longer holding periods, despite having higher volatility. Their strong performance has not been linked to higher concentration risk, however, which has been associated with large-cap stocks. Concentration risk arises when a substantial portion of a portfolio is invested in the shares of a few companies.
Two ways to measure concentration risk
To gauge a portfolio’s concentration level, we can calculate the ratio of the portfolio’s effective number of stocks to total number of stocks.1 The ratio summarizes the weight distribution of a portfolio: the lower the ratio, the more concentrated the index.
Across regions (represented by the MSCI USA, MSCI World ex USA and MSCI Emerging Markets Indexes), the ratio was much higher for small-cap indexes, indicating lower concentration risk compared to the corresponding regional parent indexes.
An alternative way to assess portfolio concentration is asset-level risk-contribution analysis. As of Sept. 29, 2023, the top 10 index constituents of the MSCI USA Small Cap, MSCI World ex USA Small Cap and MSCI Emerging Markets Small Cap Indexes contributed a much smaller portion of total index risk — 3.0%, 2.8% and 4.1%, respectively — than the portion contributed by the top 10 constituents of their parent index — 35.3%, 12.9% and 28.4%, respectively. Thus, the addition of small-cap allocations to more concentrated larger-cap portfolios could be a potentially diversifying strategy.
