Size was one of the first anomalies (or factors) identified in the evolution of factor investing theory. Specifically, the size factor anomaly reflects that small-cap stocks outperform large-cap stocks and, therefore, provide potential alpha to dividend growth investors exposed to them.
However, the size factor premium has not been without its challenges and, more recently, it has come under tremendous pressure from academic research. Let’s take a look at this factor and see if we can come to a practical conclusion on the age-old question: does size matter?
Rolf Banz first identified the size factor in 1981, and it was the first factor to challenge the capital asset pricing model (CAPM), which was the investing gold-standard at the time.
However, more recent studies and data analysis do not appear to support this supposed size effect (premium).
One of the primary reasons for this lies in the data that Banz used back in 1981. He, like most researchers, used the CRSP database. The problem is that, at the time, this database of market data was riddled with inaccuracies—especially when it came to small-cap companies.
As researchers have cleaned-up that database (specifically with data related to delistings), the size effect has seemingly evaporated. At best, the statistically-significant size premium for US smallcaps from 1927-2017 is very low when compared to the other core factors… at worst, it is nonexistent.
So where does this leave the retail trader? Should we abandon exposure to the size factor in our portfolios and look away from smallcaps?
The problem with the above conclusion is that it is based upon analysis that solely focused on size—ignoring the other factors. When we include the powerful factor of profitability (Quality), we get an entirely different picture.
All small-cap stocks are not created equal. You have value stocks and growth stocks. In general, small-cap growth stocks have low to no profitability and statistically underperform the market. This distorts the findings regarding the size effect.
In fact, Ben Felix aptly notes that, when smallcaps are filtered by profitability, recent studies find that the growth stocks are “responsible for the underperformance and statistical unreliability of the asset class as a whole.”
The traditional approach to determining the size factor for smallcaps was to simply filter by size alone. In other words, small minus big (aka SMB). However, studies demonstrate that when junk smallcaps (i.e., growth stocks) are also filtered out, the size premium returns. Specifically, the size factor (SMB) produced a 1.57% premium from 1975-2017 with the additional filter of quality minus junk (QMJ) .
In their recent study, Asness, Frazzini, Israel, Moskowitz and Pedersen (2018) noted that, while the size premium has been challenging to say the least:
Specifically, they found that when quality is controlled, “A significant size premium emerges, which is stable through time, robust to specification, not concentrated in microcaps, more consistent across seasons, and evident for non-priced based measures of size.”
In fact, they conclude that:
Since the right kind of size does matter (at least for investors), how does a retail investor gain exposure to it?
Again, size is not a primary factor and it can be a difficult one for the retail investor to gain exposure to in terms of practicality.
The reality is that it’s easy to say and hard to do. The vast majority of small-cap ETFs and funds skew their holdings towards growth (aka junk) stocks. Therefore, using these as a potential vehicle to tap into the size factor simply won’t work. The underperformance of the junk will cancel out (at best) the premium provided by the overperformance of the quality holdings.
The good news is that this is where the retail investor has an advantage. We can be very flexible and selective in how we target smallcaps. Rather than bundling the good with the bad, we can filter by quality and build a portfolio that has beneficial size exposure.
Obviously, this takes some willingness and effort to accomplish—but the reward is potential alpha over the long run.
At Wicked Capital, we do integrate the size factor into our dividend growth strategy.
First, the filtering of quality is already accounted for—this is why the core factors of value and quality form the foundation of our selection process.
Second, we then seek to maintain an allocation of small- and micro-cap holdings to gain exposure to the secondary size factor.
Again, we feel that size is not a primary selection factor for us. Rather, it is a secondary factor that steers our portfolio allocations with regards to market capitalization. First and foremost, we always want exposure to value and quality. Size exposure simply provides additional potential alpha within our overall portfolio.
What do you think about the size factor? Does size matter? Or, is there no real premium gained by exposure to it? And if it matters to you, how do you leverage it in your DGI portfolio?
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