The small-cap premium is a well-understood and accepted phenomenon. Numerous academic studies show that, over time, smaller companies consistently show higher long-term returns than both mid and large-caps in all markets and sectors.

Theory and evidence suggests that this premium is paid to compensate the investor for the higher price-volatility and business risk of holding smaller companies. Small-caps tend to exhibit high beta because they tend to be riskier, less diversified and more closely geared to their local economies.

“Small-cap companies act like a leading economic indicator,” as Andrew Neville, lead portfolio manager of the global small-cap strategies at Allianz Global Investors, puts it. “They start to outperform three to four months ahead of the economy reaching its lowest level of growth.”

That high beta can lead to outsized returns in economic recoveries – and unfortunately the performance advantage of smaller companies in the current economic environment is no secret. Over the past five years the MSCI World Small Cap index has increased by 19.2%, while the MSCI World index has risen by 13.4%. While the small-cap premium is appealing, can one take for granted that one is always paid that premium by the market? Do investors considering small-caps need to avoid the classic trap of buying at too high a price by implementing a ‘smart’ small-cap investment strategy, or timing their entry?

Not according to some managers. “For every 10-year rolling period, global smaller companies have outperformed global large companies by a sufficient margin to compensate for their higher risk,” says Neville. “This is an asset class that rewards over the long term.”

The best way to capture the small-cap premium is to have a constant allocation, agrees Rune Sanbeck, head of EMEA institutional at Dimensional Fund Advisors. “Many investors try to time their market decision – increasing an allocation to this asset class when they believe that it is undervalued relative to companies with a larger market cap. But the academic research shows that it is difficult to get the timing of asset allocation decisions right. There is less success for market timing than there would be for random decisions.”

There is another good reason for keeping a constant allocation to small-cap: trading costs are so high – up to 6% in emerging markets – that they can quickly erode any returns.

Once an investor has decided that they want a small-cap allocation – tactical or strategic – the next decision is what kind of exposure to have and how to get it. Active or passive? Qualitative or quantitative? Country-based, regional or global?

The very nature of small companies should make them the ideal hunting ground for active managers. Even on a regional basis, the small-cap universe is immense, making it difficult for any fund manager to have an in-depth knowledge of every single company, which throws up plenty of market inefficiencies.

Despite the enormity of the task, there are some fund managers who offer access to global small-cap. “A smarter way to do small-cap is do it on a global basis so that you are exposed to companies in Europe, the US and Asia,” Neville suggests. “History shows that if smaller companies in one region have the strongest performance in one year, they are unlikely to have the strongest performance the following year. Investing globally ensures the investor has constant exposure to all the regions, rather than trying to time the regional asset allocations, which is impossible to get right.”

Andy Barber, technical director of manager research at Mercer agrees: “Taking a global approach to small-caps ensures that the investor has access to the widest possible opportunity set within the small-cap universe which a skilled investor, in theory, should be able to exploit.”

But it is not easy to find a global active manager: the resources required are immense and expensive for a strategy that is, by definition, capacity-constrained, cyclical in its assets under management, and not universally held by investors.

“This is not an asset class that you can cover with a team sitting in London or in San Francisco, trying to pick a Japanese small company when the management team does not speak English and all the research is in Japanese,” Neville insists.

But traditional active managers are not the only way to access global small-caps.

“The small-cap universe lends itself to a quantitative approach, as developments in computing power allow managers to process the immense amount of data available,” says Barber.

Sanbeck agrees, and claims that the quant approach yields more consistent results than more qualitative active management.

“If you are a stockpicker who can perform well, then the results can be phenomenally good,” he concedes. “But there is plenty of independent academic research that shows stockpicking is less successful than you would expect [compared with] a random selection.”

A successful quant approach to smaller companies can be disarmingly simple: rather than focusing on trying to choose the right companies that will do well, investors can enhance the small-cap premium efficiently by ensuring that they invest in the smallest companies, Sanbeck argues. “The return over time is larger for those companies that make up the bottom tenth of the small-cap universe,” he says.

Getting access to those smaller companies, however, it is not as simple as replicating an index. The Russell US 2000 index buys companies from the sixth decile down to the ninth, but history shows a huge increase in return between the ninth and tenth deciles – 3.8% annualised between 1926 and 2012, according to Sanbeck.

That’s not the only disadvantage of using a passive approach for small-cap investing. From an academic perspective, global small-cap indices appear well designed and closely resemble equally-weighted indices – which have been shown to outperform cap-weighted indices in the large-cap realm. The MSCI World Small Cap index includes some 4,200 stocks, with the largest company weighted at less than 0.2%.

But it is difficult to design an investable passive product that follows this benchmark accurately. You simply have to buy many more stocks than an equivalent product in the large-cap space, which makes the process much more expensive, to the point of unfeasibility.

“We prefer to create our passive products through physical replication,” says Ursula Marchioni, head of iShares EMEA equity strategy and ETP research. “For a small-cap global index, given the number of constituents, we would have to sample heavily to avoid transaction and access costs. But this would reduce the overall number of stocks and deliver a sub-optimal performance to the end investor. We think the smarter way of implementing a global small-cap strategy is through regional indices, which deliver better tracking quality to the investor.”

So investors can go global or they can go passive – but it is tricky to do both unless they construct their own portfolio of regional exposures. This shows how important it is to define and weigh up your investment beliefs about small-cap strategy. The core question is whether you believe the small-cap premium can survive even the highest market valuations, allowing you to allocate strategically or permanently. But it is almost as important to weigh up the advantages of global and regional approaches, and qualitative and quantitative approaches (including passive), and how they constrain one another.