1. INTRODUCTION

Size investing refers to the strategy of buying small cap stocks. Small cap stocks are companies with relative low market capitalization. Market capitalization is simply measured by the stock price multiplied by the outstanding number of shares. The first study which links higher risk adjusted average returns with smaller stocks is Banz (1981) [1]. More prominently, Fama and French (1992, 1993) [2], [3] integrate the size effect as one of three factors in the famous Fama French three factor model. Partly because of that, size is one of the most popular applied strategies in the investment management industry and still considered to be a key factor in empirical asset pricing. However, the out-of-sample evidence over the last three decades does not look promising, see Ang (2014) [4] and Asness (2015) [5]. Asness (2015) [5] report: “Considering a long sample of U.S. stocks and a broad sample of global stocks, we confirm the common criticisms of the standard size factor: a weak historical record in the U.S. and even weaker record internationally makes the size effect marginally significant at best, long periods of poor performance, concentration in extreme, difficult to invest in microcap stocks, concentration of returns in January, absent for measures of size that do not rely on market prices, and subsumed by proxies for illiquidity.”

2. PRACTICAL IMPLEMENTATION

Size can be implemented by buying small cap stocks in a long only portfolio. Alternatively, size exposure can be can gained through small and also mid cap ETFs, which are available on a low-fee base for most developed stock markets. For institutional investors one practical issue of investing into small cap stocks are trading costs or trading impact, as trading volumes are often too low to make it scalable for bigger portfolios. In that case mid cap investing can be considered an alternative approach. Mid caps are stocks ranging around the median market capitalization. However, some studies show that the size effect is a result of the performance of the smallest 5% of stocks, see Crain (2011) [6]. An alternative way of investing into small caps is shown be Asness (2015) [5] control for junk stocks in the small cap universe and report a significant size premium.

3. RISKS OF SIZE INVESTING

Small caps are typically high beta stocks, hence, long only small cap investing comes with leveraged market exposure. The average beta of small cap stocks ranges around 1.3-1.5 depending on the index and data set. Another risk faced concerns liquidity --- in times of financial distress, as liquidity tends to dry out during extreme periods, for example, during the financial crisis 2007-2009. Another important risk, is the uncertainty regarding the existence of the size effect. As mentioned already in the introduction, the size effect is a controversial topic in the finance literature. Some authors argue that the size effect discovered in the beginning of the 1980s is the result of data-mining, due to the weak performance in the post-publication period. Others say that reason behind the lack of positive returns is the near-efficiency introduced by Grossman-Stigliz (1980), which says, that market participants adjust rapidly to publications and hence, ultimately led to the disappearance of the anomaly. Either way, investing into small caps because of higher expected risk-adjusted returns might not deliver what is expected.

4. THEORETICAL EXPLANATIONS

Similarly as with other factors, size investing comes with additional systematic risk. Lower capitalized stocks tend to be more risky than higher capitalized stocks, controlling for market exposure. Moreover, if this risk is systemic, such that it cannot be diversified away among small stocks, the additional risk faced is compensated by higher expected returns such that the size effect can be explained by classical asset pricing theory. However, this argument loses strength considering the findings of Asness (2015) [5]. The authors show, that high quality small stocks, characterized by less volatile returns patterns and more sound fundamental values, carry a significant size premium. This results stays in stark contrast to the risk based justifications of the size effect. Additionally, liquidity risk is also often seen as the key driver behind the size effect, as many studies suggest, for an overview see Crain (2011) [6]. According to these studies size proxies liquidity and hence, justifies the difference in average returns as compensation for the risk.

5. SUMMARY

The size effect is an important factor, mainly because of its presence both in the industry but also in the academic literature, less so because of its average returns. For constrained, long only investors small cap investing is an easy access to leveraged market exposure as size exposure can be gained fairly easily and for relative low costs (of course a cleaner way to do so is to invest into a portfolio of high beta stocks). Size products are in high supply for most developed markets, however, be aware that the simple size effect is not the most strongly supported source for an additional risk premium.

References

1. The relationship between return and market value of common stocks,
   Banz, Rolf W.
   , Journal of Financial Economics, Volume 9, p.3–18, (1981)
   
2. The cross-section of expected stock returns,
   Fama, Eugene F., and French Kenneth R.
   , The Journal of Finance, Volume 47, Number 2, p.427–465, (1992)
   
3. Common risk factors in the returns on stocks and bonds,
   Fama, Eugene F., and French Kenneth R.
   , Journal of Financial Economics, Volume 33, Number 1, p.3–56, (1993)
   
4. Asset Management: A Systematic Approach to Factor Investing,
   Ang, Andrew
   , (2014)
   
5. Size Matters, if You Control Your Junk,
   Asness, Clifford S., Frazzini Andrea, Israel Ronen, Moskowitz Tobias J., and Pedersen Lasse Heje
   , Available at SSRN 2553889, (2015)
   
6. A literature review of the size effect,
   Crain, Michael A.
   , Available at SSRN 1710076, (2011)