The conventional size (market capitalization) premium is notoriously weak since discovery almost 40 years ago. Does this poor live track record mean it is useless to investors? In their September 2020 paper entitled “Settling the Size Matter”, David Blitz and Matthias Hanauer examine whether the size premium is exploitable as a standalone anomaly or in combination with other anomalies. They consider six versions of a size factor from prior research, as follows:
- Adjusted for value – average of three small-cap stock portfolios minus average of three big-cap stock portfolios after sorting for book-to-market ratio.
- Adjusted for value, investment and profitability – average of nine small-cap stock portfolios minus average of nine big-cap stock portfolios after separately sorting on the other three factors.
- Adjusted for profitability – average of three small-cap stock portfolios minus average of three big-cap stock portfolios after sorting for profitability.
- Adjusted for quality – average of three small-cap stock portfolios minus average of three big-cap stock portfolios after sorting for quality.
- Adjusted for quality beta – average of three small-cap stock portfolios minus average of three big-cap stock portfolios after sorting for quality beta.
- Adjusted for size, investment and return on equity – average of nine small-cap stock portfolios minus average of nine big-cap stock portfolios after separately sorting on the other three factors.
All factor portfolio segments are capitalization-weighted, and all returns are in U.S. dollars. They consider regressions (implying long-short implementations) and long-only sides of these factors. They also consider size factor definitions that do not overweight size inputs, as do those above. Using data required by these definitions for U.S. stocks since July 1963 (or January 1967 for some inputs) and for international stocks since July 1990 (or July 1993 for some inputs), all through December 2019, they find that:
- For U.S. data, most definitions produce a weak size effect (monthly gross regression premiums in the range 0.02% to 0.18%). Only regressions of size on quality factors generate significant monthly gross premiums (as high as 0.60%). For international data, no definitions expose a significant size premium.
- Moreover:
- The U.S. size premium appears unexploitable because the retrospective (full-sample) quality-adjusted premium dissipates when controlling for quality in real time.
- Full-sample regression premiums disappear when regressing on just the long sides of other factors, implying that size tilts do add no value for long-only factor investors. Only investors with positions in the short sides of quality factors (short junk) benefit from size exposure.
- Adjusting the other factor definitions using weights of 90% for big-cap and 10% for small-cap segments instead of 50% and 50% significantly reduces other factor premiums, indicating that overweighting small-cap stocks is desirable as a means of boosting performance of other factors, such as value and momentum.
In summary, evidence indicates that size is weak as a standalone factor but may give a material boost to other stock factors.
Cautions regarding findings include:
- Findings are gross, not net. Accounting for frictions involved in periodic factor portfolio reformation and, if applicable, shorting would reduce all returns and alphas. Reformation frictions and shorting costs vary over time and across types of stocks, such that net findings may differ from gross findings.
- Forming portfolios as described is beyond the reach of most investors, who would bear fees for delegating to a fund manager.
- The paper does not address explicit strategies for factor premium exploitation.
