Is Size A Useful Investing Factor Or Not?

In his famous 1981 paper, “The Relationship Between Return and Market Value of Common Stocks,” Rolf Banz found that small firms have higher risk-adjusted returns than large firms. This was one of the first major challenges to the capital asset pricing model (CAPM) and market efficiency in general. However, its failure to generate statistically significant premiums post-publication has called into question the premium’s existence.

In their 2018 study, “Fact, Fiction, and the Size Effect,” (Summary) Ron Alquist, Ronen Israel, and Tobias Moskowitz, members of the research team at AQR Capital Management, concluded that there is no strong empirical evidence to support a size premium.

However, they did add that size can be an important factor for explaining mutual fund returns and that other factors, such as value, tend to be more powerful among smaller stocks — which is not supportive of there being a small-cap versus large-cap effect, but might be a reason to overweight small-cap stocks in long-only constrained factor portfolios.

Extending the 2018 Journal of Financial Economics paper, “Size Matters, if You Control Your Junk,” by Clifford Asness, Andrea Frazzini, Ronen Israel, Tobias Moskowitz, and Lasse Pedersen, they then “saved” the size effect by demonstrating that it is made much stronger (and implementation costs are reduced) when size is combined with the newer common factors of profitability, quality, and defensive (low beta). Alquist, Israel, and Moskowitz noted:

“Controlling for quality resurrects the size effect after the 1980's and explains its time variation, restores a linear relationship between size and average returns that are no longer concentrated among the tiniest firms, revives the returns to size outside of January and simultaneously diminishes the returns to size in January — making it more uniform across months of the year, and uncovers a larger size effect in almost two dozen international equity markets, 30 where size has been notably weak.

"These results are robust to using nonmarket-based size measures, making the size premium a much stronger and more reliable effect after controlling for quality.”

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Disclosure: My firm, Buckingham Strategic Wealth, recommends Dimensional funds in constructing client portfolios.

 Performance figures contained herein are hypothetical, unaudited and ...

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