Size is long standing factor, small-cap stocks had an impressive run many years ago. With big tech stocks dominating, is the size factor still relevant? Click here to read.
Factor investing has gained much popularity in the last few years. Factors are attributes that are likely to influence investment returns; for example, the low volatility factor may outperform by focusing on assets with lower fluctuations than others, while the momentum factor may generate potentially higher but riskier returns.
Size was one of the earliest investment factors identified as a key driver of market outperformance. Together with market risk and equity value, they formed the basis of the Fama-French Three-Factor Model1 developed in the early 1990s by University of Chicago professors Eugene Fama and Kenneth French.
The size factor postulates that small-cap stocks should generally outperform their larger counterparts as investors require higher returns to compensate for the increased risks of investing in smaller stocks. Such risks may include lower liquidity, higher volatility, higher drawdowns, etc. Returns for the size premium have not been as consistent as, say, low volatility. Nonetheless, recent research indicates that size has remained an important factor and can significantly contribute to a portfolio’s returns through its differentiated profile.2
Another rationale of small-cap stocks’ ability to outperform is that they have better growth prospects than larger, more established companies. Small-cap stocks have fewer equity analysts’ covering them and their growth potential may be less well known, which in turn plants the seed for future outperformance if they do manage to grow and gain more attention.
Think about small-cap stocks as buying a property in a so-called “up and coming” area. You bought it before it became trendy, before it became a destination, and you paid way less than those who try to move in now. Remember when Facebook was a startup and the Bay Area was affordable? Of course, there are no sure wins when you buy small-cap stocks and some of them do fizzle out. Timing and luck sometimes go hand in hand.
How is Size Measured?
For equities, the size factor can be accessed by purchasing small- and mid-cap stocks. An equal-weighted exposure to a large-cap index is another diluted way to access the size factor. The same principle applies to fixed income as equal weights can be used.
At The Index Standard, we think the size factor is highly cyclical and the timing of position entry needs to be carefully considered. The size factor has not performed well in the past few years, especially in the US where market returns has been driven by large technology stocks such as Alphabet (Google), Amazon and Microsoft.
Visit The Index Standard library for information on other popular investment factors.
- Eugene F. Fama & Kenneth R. French, Common Risk Factors in the Returns on Stocks and Bonds, 33 J. FIN. ECON. 3 (1993).
- Is There Still a Role for the Size Factor in Multi-Factor Portfolios. Scientific Beta. Felix Goltz et al. December 2019