Most investors are aware of the so-called January Effect, in which small-cap stocks outperform large-caps during the first weeks of the calendar year.

Less well known is that the preconditions for this seasonal tendency are created in the fourth quarter -- and that shrewd investors can profit from it.

Small-cap stocks outperform the large caps at the beginning of the year, in large part, because secondary stocks are market laggards at the end of the previous year.

To be sure, this period of market-lagging performance extends over a longer period than the period in early January in which the small-caps shine. So, it is not as evident a pattern to the casual observer as what happens in the first weeks of January.

But, it is a marked seasonal tendency, nonetheless.

Before discussing why this pattern might exist, let’s first review the data. The table shown subsequently lists the average monthly or quarterly returns that extend back to 1926 as calculated by University of Chicago finance professor Eugene Fama and Dartmouth finance professor Kenneth French:

To be sure, given volatility in the data, the difference in returns between those in the 2nd and 3rd quarters and those in the 1st or 4th is not statistically significant. But, the difference between the small-caps’ performance at the beginning and end of the year is very significant.

Marked as this pattern is, however, we should not place too much weight on it unless there is a sound theoretical reason for why it should exist. Fortunately, this requirement would appear to be met in this case.

It turns out that many money managers’ incentives lead them to make their portfolios look more and more like the S&P 500 (TICKER:SPX) as the year progresses. That’s because so many of those managers’ year-end bonuses are dependent on beating this widely used benchmark.

According to researchers who have studied them, these incentives cause small-cap stocks to be at their most unpopular at the end of the year and their most popular at the beginning.

Consider money managers who, right now, are ahead of the S&P for year-to-date performance, for example. These money managers know that, so long, as they hold onto their lead through the end of the year, they are likely to earn a handsome bonus. And, the money managers can lock in that lead by shifting their portfolio holdings to primarily S&P 500 stocks.

Managers who resist these incentives and invest in small-cap stocks run the risk of falling below the S&P 500 by year’s end. So, over the last months of the year, their incentives to take those risks will be more and more outweighed by the desire to lock in a lead.

Once January arrives, however, these managers’ compensation slates will be wiped clean. That will be when incentives to invest in small-cap stocks will be stronger than at any other time of the year -- while their incentives to invest in large-caps will be weaker than at any other time.

A not-dissimilar situation exists for managers who are currently behind the S&P 500 for year-to-date performance. To be sure, they are not currently slated to earn any bonus for beating this benchmark.

But, they do have another incentive, one that is just as powerful, if not more so: To avoid ending the year’s rankings at or near the bottom, an eventuality that might very well cost them their job.

So, as the year comes to a close, they will increasingly want to play it safe and invest in the larger-cap stocks that dominate the S&P 500.

The only managers for whom these incentives are not likely to be very powerful will be ones who, right now, are at the very bottom of the year-to-date rankings.

Note carefully that this explanation for why the January Effect exists differs from the more widely known theory based on tax loss selling. According to that theory, investors realize losses at the end of the year in order to shelter other capital gains income, and this tax-loss-selling disproportionately affects small-cap stocks because they are much less liquid than the small-caps.

An implication of this tax-loss-selling theory is that, although small-caps will outperform large-caps in January once this selling has come to an end, both small-caps and large-caps should perform well at the beginning of the year.

But, that is not what researchers have found. According to one study by Lucy Ackert, of Kansas State University and the Federal Reserve of Atlanta, and George Athanassakos, of the University of Western Ontario, while small-caps perform extraordinarily well during January, large-cap stocks actually perform at a below-average rate.

This is exactly what one would expect, the researchers argue, on the theory that managers are pulling money out of large-caps in January and reinvesting the proceeds in small-caps.

Those of you who are impressed by this theory and, therefore, inclined to favor large-cap stocks over the next couple of months should take a look at the list (in the subsequent table) of those large-caps currently recommended by the newsletters that have beaten a buy-and-hold in the stock market over the last decade:

Mark Hulbert is editor of the Hulbert Financial Digest, a service of MarketWatch that, for nearly 24 years, has tracked the performance of investment advisory newsletters. A section of the MarketWatch website called "Hulbert Interactive" (marketwatch.com/hulbertinteractive) allows users to conduct extensive research on the HFD database.

Mark can be contacted via email at mhulbert@marketwatch.com