Busting the Myth About Size Premium by Research Affiliates

In the latest piece from Research Affiliates, Vitali Kalesnik and Noah Beck examine the size premium—the outperformance of small-cap stocks—which has been a fixture in factor investing for an entire generation. But a critical examination of updated evidence from the United States and 17 other countries throws its very existence into question.

A recent Research Affiliates article by Hsu and Kalesnik (2014) concluded that there are at best three factors from which investors can benefit through passive investing: market, value, and low beta. The size premium was conspicuously missing from that short list. In this article we explore empirical evidence behind the size premium in more detail. The summary below offers a preview of our findings. We let the reader examine the evidence and draw his or her own conclusion. In our opinion the preponderance of evidence does not support the existence of a size premium.

Size Premium

We are not arguing that investors should stop investing in small stocks. A portfolio of small stocks offers a certain level of diversification in an investment program dominated by large-stock strategies. Moreover, major anomalies are stronger in the universe of small stocks (likely because small stocks are more prone to mispricing). Thus, small stocks have the potential to serve as an alpha pool for skilled active managers and rules-based strategies that primarily target factors other than size. Nonetheless, we are skeptical that investors will earn a higher return simply by preferring small stocks over large.

Size Premium – Updating the Evidence

Banz (1981) reported that small-cap stocks outperformed large-cap stocks. For the subsequent decade the phenomenon Banz observed was considered a curious anomaly. The situation changed in 1993, when Eugene Fama and Kenneth French suggested that small stocks may expose investors to some undiversifiable risk that warrants a higher required rate of return. At that moment, the size factor took its place alongside the market and value factors in the original Fama–French three-factor model. Carhart (1997) then made the case for momentum as a fourth return factor. Today the most standard equity pricing model used in academia includes four factors: market, value, size, and momentum.

But consider this: What if a large company were split, on paper only, into two small companies? Suppose there is no change in operations, and imagine that one of the small companies booked all the cash flows on even-numbered days of the month, and the other one accounted for all the cash on odd days. In this scenario, it would be most surprising if the small companies both delivered higher returns than the original large company. Yet the size premium is precisely based on the expectation that small-cap stocks will outperform large-cap stocks!

Size Premium

Online at: “Busting the Myth About Size Premium

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Other research and commentary from Research Affiliates is available here.

Background on Research Affiliates is available here.