One of the first breaks with the idea of market efficiency was the discovery of a size premium. This is the basic idea that smaller stocks, especially very small ones, tend to outperform largest ones, on average, over time. So size was perhaps the first market anomaly from a factor investing standpoint.
Now, many other factors have been discovered, but many researchers are losing faith with the size premium. This is not to say that a size factor is necessarily completely absent or that you should bet against it, but that other factors and other investment strategies perhaps appear more compelling.
The paper is ‘Fact, Fiction and the Size Effect’ by researchers at AQR and Yale. First off though there is historical evidence that historically smaller stocks can outperform, this outperformance appears extremely volatile relative to the gains you may get. Ideally, you want factors to produce return with less ups and downs along the way. As such on a risk-adjusted basis size looks less compelling compared to other factors such as value, momentum and low-volatility. To be clear, those other strategies can be volatile too, but deliver higher historical returns in compensation for the risk. Also, once beta is controlled for the usefulness of size reduces further, so some of the return may be more to do with risk, than directly related to size.
Another issue that may have been an issue with the first size research was missing data. Small stocks do delist from the market relatively frequently, more often than not that’s not for good reasons and causes a loss for investors. If that’s not captured in the returns data fully, as appears to have been the case with early papers on the size effect, then the returns to investing in smaller stocks maybe overstated. So now the data has improved, maybe the size premium was never quite as large as we thought.
A Lower Tier Factor
So though the size effect may exist, it appears to be weaker than several other factors. Recent research on the Chinese market came to a similar conclusion, finding that size may work on a risk-adjusted basis, but is clearly weaker than low volatility and value effects. And of course, there’s a debate as to the robustness of the value factor too.
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So it appears that size may be coasting on its reputation as one of the first factors to be discovered. At the time, it was extremely interesting to find a simple rule that appeared to beat the market, at a time when a firm belief in market efficiency was ascendant in academia.
As such, the size premium was certainly helpful in framing the start of a move away from more constraining versions of market efficiency. However, in recent history better quality data and the discovery of other factors and their interactive effects has lead to an understanding that the size premium may well exist, but is among the weaker factors in absolute and risk-adjusted rankings. If it hadn’t been the first to be popularized it may have received much less attention.