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Financial research has uncovered many relationships between investment factors and security returns. One of the most-asked questions I receive is whether such relationships will continue after that research has been published. Said another way, if everyone knows about a factor premium, should we expect it to continue outside of the sample period?
In 1981, Rolf Banz’s “The Relationship Between Return and Market Value of Common Stocks” concluded that market beta doesn’t fully explain the higher average return of small stocks. Banz found that from July 1926 through 1981, the monthly size premium averaged 30 basis points.
However, post-publication, from January 1982 through December 2017, the monthly premium has averaged just 8 basis points. Skeptics note that when we look at annualized (compound) returns, the data looks even worse. For example, some have pointed out that from 1982 through 2017, while the large-cap Russell 1000 Index returned 11.7%, the small-cap Russell 2000 Index returned just 10.6%. Thus, the size premium has been called into question, and some investors wonder whether it has shrunk or even disappeared.
Today it’s much easier and less costly to diversify the risks of small-cap stocks through mutual funds and ETFs than it was during the period Banz studied. In addition, trading costs, in the form of both commissions and bid/offer spreads, have come way down. Thus, there are logical arguments for why the size premium may have diminished over time.
The size premium issue is complicated by the well-known anomaly that, even though small value stocks have indeed provided higher returns than large value stocks, small growth stocks have provided lower returns than large growth stocks. Using the Fama-French research indexes, from July 1926 through November 2017, the annualized returns for the four asset classes are:
- Small value: 14.8%
- Large value: 12.1%
- Large growth: 9.8%
- Small growth: 8.7%
While producing lower annualized returns than large growth stocks, small-growth stocks also exhibited higher volatility – the annualized standard deviation of returns was 18.3% for large growth and 26.0% for small growth. Note that the standard deviations for large value and small value were 24.7% and 28.2%, respectively.
From the viewpoint of traditional finance, while the returns and volatility of large growth, large value and small value stocks line up as they should (higher returns are positively correlated with higher volatility), the returns and volatility of small growth stocks do not. This is why small growth stocks have been referred to as the “black hole” of investing – and they present an anomaly.
Read the full article by Larry Swedroe, Advisor Perspectives