Size Factor

The size factor captures the idea that smaller companies, measured by market capitalisation, tend to earn higher returns than larger companies over long periods. It was one of the first anomalies to challenge the capital asset pricing model and became part of the influential Fama French three factor model. But the size effect has been weaker and less consistent since it was published, and research suggests it works mainly when combined with other factors such as quality.

The original evidence#

• Rolf Banz (1981) found that small NYSE stocks had higher risk adjusted returns than large stocks from 1936 to 1975.
• Fama and French (1992, 1993) included size (SMB, small minus big) as a factor alongside market and value.
• Much of the historical premium was concentrated in the very smallest stocks and in January, the so called January effect.

Why might small caps earn more?#

The weakened size effect#

Size and quality#

Research by Asness, Frazzini, Israel, Moskowitz and Pedersen (2018), in "Size Matters, If You Control Your Junk", found that small caps include many low quality, unprofitable companies that drag down returns. Among high quality firms, a size premium reappears and is more stable across time and countries. This suggests size works best combined with quality. See Quality and Profitability Factors.

Practical challenges#

Small caps and the economic cycle#

Small caps tend to be more sensitive to the economy and credit conditions. They have often done well early in economic recoveries and poorly in recessions and when interest rates rise sharply, partly because many small companies carry floating rate debt. See Business and Economic Cycles.

How investors use size#

• Small cap index funds and ETFs, such as those tracking the Russell 2000.
• Small cap value and small cap quality tilts, which combine size with other factors.
• Factor models use size to explain portfolio returns and judge whether a manager's outperformance came from a small cap tilt. See Factor Models.

Frequently asked questions#

What is the size factor?#

The tendency of small companies to earn higher returns than large companies over long periods, measured in factor models as small minus big (SMB).

Does the size premium still exist?#

It has been much weaker since its publication in the 1980s, but research suggests it is stronger among high quality small companies.

Why are small caps risky to trade?#

Because they have wider spreads, lower liquidity, higher volatility and higher failure rates, which raise costs and risks.

Next, learn about the low volatility anomaly in Low Volatility and Defensive Factors.