BAM’s Swedroe Discusses Size Effect

In an article on size effect, BAM director of research Larry Swedroe discusses the ongoing debate on the size effect—the phenomenon whereby small-cap stocks on average outperform large-cap stocks over time–which was first documented by Rolf Banz in 1981 but “basically disappeared in the United States” after Banz’s paper. Here are some highlights of the article, which cites a variety of research including papers by AQR and others:

  • Part of the size premium may be “the equity market premium in disguise” since small-cap stocks tend to have larger market betas than large-cap stocks.
  • The size premium “has not been statistically significant outside the U.S.” and is found primarily in micro-caps (the bottom 5% of all stocks by market capitalization).
  • “It is not robust to other measures of size that do not include market capitalization.”
  • The size effect is not a strong source of expected returns on its own, but is made stronger when size is “combined with the newer common factors of profitability, quality and defensive (low beta).”
  • The quality factor is important with respect to the size premium: “Stocks with very poor quality (i.e. ‘junk’) are typically very small, have low average returns, and are typically distressed and illiquid securities. These characteristics drive the strong negative relation between size and quality and the returns of these junk stocks chiefly explain the sporadic performance of the size premium and the challenges that have been hurled at it.”

The article concludes: “These findings have important implications for investors when implementing passive strategies that include exposure to small stocks. How a fund defines its universe of small stocks eligible for purchase can make a significant difference in performance.”