Small-Cap Stocks vs. Private Equity: Comparing Risks and Returns

In the world of investing, it has long been accepted that risk and return are close counterparts. You can’t typically achieve higher returns without also taking higher risks, and vice versa. That said, the notion of risk can be subjective. Driving a powerful car at a high speed may be risky for the average motorist, but it’s second nature to a racing driver. As Warren Buffett, hailed as one of the world’s most successful investors, once said: “Risk comes from not knowing what you are doing.”

But how can risk be measured objectively? In order to make a statistically valid comparison between the risks and returns of small-cap stocks and private equity, we must use credible and recognized metrics.

One of the most widely accepted methods is to measure volatility, the degree to which a market price has deviated from its primary trend, as well as the frequency with which those deviations have occurred. The more deviations there have been – and the bigger – the higher the perceived risk.

Market volatility in perspective, taking the price of the S&P 500 as an example
Source: Visual Capitalist

Selecting Benchmarks

Next up, we need a suitable proxy for each asset class that demonstrates performance over our chosen measurement period, 20 years from January 2004 to January 2024. We decided to focus on US securities only seeing as they have the longest, most complete, and most detailed statistical records.

In order to ensure we compared like with like, we narrowed the private equity focus to venture capital only. This eliminates the mega-funds that dominate the US private equity landscape, which tend to specialize in buy-outs and other strategies that don’t align with the main purpose of this research: Measuring the correlation, or lack thereof, between listed and unlisted early-stage investing.

Accordingly, the calculations* were made to measure volatility and returns for small caps, venture capital (VC), and, to provide a more comprehensive market context, larger listed companies.

* These calculations were made using the Russell 1000 (RUI) as the US large-cap stock market, the Russell 2000 (RUT) as the US small-cap stock market, the MSCI USA Micro Cap Index as the US micro-cap stock market, and the Cambridge Associates US Venture Capital Index for venture capital. Sources: Yahoo Finance, MSCI, Cambridge Associates.

The methodology behind the calculations focused on establishing parity in the measurement frequency of the aforementioned indices to a quarterly basis. This adjustment was made due to the fact that investment-level performance information of venture capital funds behind the Cambridge Associates benchmark is drawn from the fund managers' quarterly and annual financial statements. The chart is made for illustrative purposes only, as neither of the indices can be directly invested in. These indexes are simply measures of the performance of their constituent securities.

As of June 2024, the Russell 2000 constituents had a median market capitalization of USD 900 million, with the average being a far-from-small USD 4.5 billion, and the biggest at no less than USD 47.4 billion. Given these figures, we needed an alternative that tracked genuinely small listed companies or, in other words, those with characteristics closest to the universe of unlisted companies from which VC funds select their investments.

With this in mind, we selected the MSCI USA Micro Cap Index, which covers 1,170 stocks. The largest company in this index has a market capitalization of USD 1.4 billion, while the smallest has a market capitalization of just USD 2.5 million. The index is calculated on a similar basis as the Russell indices, making it a valid comparator for our purposes.

Comparing Returns: Cumulative and Annualized

Cumulative and 20-year annualized rate of return for examined indices*

If returns were the only consideration, the chart above would decisively favor venture capital and provide all the information we need. Indeed, the CA US Venture Capital Index, representing the venture capital market, stands out with an impressive cumulative return of 793.85% (compared with 355.57% for large-cap and 314.35% for micro-cap stocks) and an annualized return of 11.57% (compared with 7.88% for large-cap and 7.37% for micro-cap stocks).

However, if we are to listen to Warren Buffett (and our own common sense), we must also consider the risks of investing in each asset class.

Risk-Adjusted Performance: Comparing Sharpe and Sortino Ratios

Investment analysts apply a variety of measurements to quantify risk. Chief among these are Sharpe and Sortino ratios.

The former was devised in 1966 by the Nobel laureate US economist, William F. Sharpe, now Emeritus Professor of Finance at Stanford University's Graduate School of Business. Widely used by professional investors, it compares deviations in returns over time with those from a so-called “risk-free” asset, usually, and in our case, US 3-month treasury bills. The higher the ratio, the better the risk-adjusted return. A ratio greater than 1 signifies a return in excess of what can be attributed to price volatility alone.

Sharpe ratios for examined indices*

Once again, among our four benchmarks, US venture capital is the clear winner, with a Sharpe ratio of 0.65, compared to 0.46 for large-cap stocks and 0.34 for small and micro-cap stocks. However, none of the four benchmarks has produced a return that exceeds the risk being taken.

Perhaps the Sortino ratio will provide further insight. It was devised by Dr. Frank A. Sortino, now director of the Pension Research Institute in San Francisco. While the Sharpe ratio considers both upside and downside volatility, Dr. Sortino argued that upward price movements should not be classified as risk. Consequently, the Sortino ratio focuses only on downward price movements.

Sortino ratios for examined indices*

As a result, venture capital showcased exceptional performance in this context, delivering returns more efficiently given its downside deviations. In fact, it’s the only one of the four benchmarks that produced a return greater than the level of risk taken.

Now, let’s try one more test to examine the extent of these downward price movements, also known as drawdowns.

Maximum Drawdowns Analysis

Maximum drawdowns (peak-to-through) for examined indices (in %)*

In this measurement, a smaller drawdown is clearly preferable, and once again, the result decisively favors venture capital. Compared to the over 45% drawdown for both US large-cap (-47.01%) and micro-cap (-53.50%) stocks, venture capital fell only 23.45%. With a score of four out of four “wins”, is it finally okay to halt our analysis and declare VC the champion in this comparison of risk and return? Not yet; there are still several qualifications and caveats that need to be addressed before we can officially do that.

Expected asset returns vs. illiquidity
Source: Realized1031

The same can be said of small caps, albeit, to a lesser extent. By virtue of their size alone, small-cap stocks tend to be more illiquid and, as previously observed, more volatile compared to larger listed securities. They are also much less widely followed by investment analysts, so there’s less transparency and less visibility. The result is this: Fewer people are examining them, let alone buying them. Interestingly enough, for the savvy investor willing to shoulder greater risks, this lack of attention can serve to hide future gems from the general public.

3. Risk Weighting

From this analysis, it’s clear that in order to enjoy higher investment returns, the investor must be willing to embrace higher risk. In practice, this is not a problem; all you have to do is apply risk weighting in the allocation of your investment portfolio.

Risk weighting is often defined within the frameworks of Modern Portfolio Theory and the Capital Asset Pricing Model (CAPM). Don’t let these complicated definitions discourage you. Actually, all it really means is to effectively diversify your portfolio so that a smaller proportion is allocated to riskier assets.

A noteworthy example to consider is the approach taken by major Swiss pension schemes such as Publica, the pension fund for federal employees. As the custodians and managers of the retirement savings of the nation’s working population, they are required – by law – to be prudent and to consider a wide range of investments across a spectrum of risk levels.

Publica’s asset allocation for open and closed pension plans in 2024 (in %)
Source: Publica

Notice how the largest weightings in such portfolios favor lower-risk assets such as government bonds, developed-market equities, and real estate, while traditionally riskier assets such as private credit (or debt) and emerging markets receive smaller allocations. As for assets that fall between these extremes in terms of risk, they are allocated weights that reflect the managers’ risk assessments.

4. Time and Timing

Another important consideration when determining your risk-weighted portfolio allocation is your age. Generally speaking, the younger you are, the more risk you can afford to take. This is because time is on your side; over the three or more decades before retirement, there is ample opportunity for markets to recover from any setbacks.

Comparison of savings of two investors over the time (in USD)
Source: Federal Reserve Bank of St. Louis

Now, this doesn’t mean that as a relatively youthful investor you should have most of your portfolio in private markets and small-caps. Ultimately, you might enjoy high returns but anxiety about the risks being taken is likely to be equally high.

Given the decades over which you are investing, however, questions of market timing are completely irrelevant. As Warren Buffett could potentially imply: the right time to buy is always now. He has persistently recommended that investors should invest passively, not worrying about what the market is doing. In particular, he has urged investors to be mindful of costs and, therefore, to buy ETFs and other passive investments with low fees and lots of liquidity.

Final Thoughts

So, all of this being said, how much should you allocate to venture capital? Taking the Publica pension fund's combined 12% allocation to private market assets (private debt and infrastructure) as a benchmark, this could also serve as a prudent guideline for venture capital allocation for younger, long-term investors.

Ultimately, there is no “correct” weighting. How much you allocate depends mostly on your personal preferences and appetite for risk, rather than on academic theories like Modern Portfolio Theory and the CAPM.

Regardless of the allocation you choose for venture capital in your investment portfolio, we invite you to consider Moonshot for exclusive opportunities in private markets, enabling access to lucrative deals in venture capital starting from just CHF 25’000.