# Size Factor

> The size factor says small companies outperform large ones over time. Learn the original evidence, why the effect weakened, the role of quality and how to trade it.

Source: https://learn.tradelabsai.com/research/size-factor/  
Track: Research and Backtesting · Level: Advanced · Updated: 2026-10-03  
Publisher: TradeLabs AI (https://tradelabsai.com). Education, not financial advice.  
Cite as: TradeLabs Learn, "Size Factor", https://learn.tradelabsai.com/research/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?

| Explanation | Idea |
|---|---|
| Risk | Small firms are riskier: more volatile, more likely to fail, more sensitive to credit conditions |
| Liquidity | Small stocks are less liquid and costlier to trade, so investors demand a premium. See [Liquidity Factor](https://learn.tradelabsai.com/research/liquidity-factor/) |
| Neglect | Fewer analysts follow small companies, leaving more mispricing |

## The weakened size effect

**Example: Size after publication**
In Kenneth French's US data, the SMB factor earned a positive premium in the decades before 1981, but its average return from the 1980s onward was much smaller and close to zero over many long periods. Large US companies, especially mega cap technology stocks, dominated returns in the 2010s and early 2020s. A small cap index fund investor over 2010 to 2024 would have trailed the S&P 500 by a wide margin. See [Signal and Alpha Decay](https://learn.tradelabsai.com/research/signal-and-alpha-decay/).

## 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](https://learn.tradelabsai.com/research/quality-factor/).

## Practical challenges

| Challenge | Effect |
|---|---|
| Trading costs | Wider spreads and higher impact eat returns. See [Costs and Slippage in Backtests](https://learn.tradelabsai.com/research/costs-and-slippage-in-backtests/) |
| Capacity | Small caps cannot absorb large amounts of capital. See [Alpha Capacity and Crowding](https://learn.tradelabsai.com/research/alpha-capacity-and-crowding/) |
| Survivorship bias | Many small companies fail; data must include them. See [Survivorship and Selection Bias](https://learn.tradelabsai.com/research/survivorship-and-selection-bias/) |
| Micro caps | The tiniest stocks drive much of the historical premium but are very hard to trade |
| Index reconstitution | Russell rebalancing creates predictable flows. See [Index Rebalancing](https://learn.tradelabsai.com/fundamentals/index-rebalancing/) |

## 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](https://learn.tradelabsai.com/macro/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](https://learn.tradelabsai.com/portfolio/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](https://learn.tradelabsai.com/research/low-volatility-factor/).

## Continue learning

- Next lesson: [Low Volatility and Defensive Factors](https://learn.tradelabsai.com/research/low-volatility-factor/)
- Previous lesson: [Quality and Profitability Factors](https://learn.tradelabsai.com/research/quality-factor/)
- Related: [Quality and Profitability Factors](https://learn.tradelabsai.com/research/quality-factor/): The quality factor favours profitable, stable, conservatively financed companies. Learn how quality is measured, the evidence and how it pairs with value.
- Related: [Factor Investing Explained](https://learn.tradelabsai.com/research/factor-investing-explained/): Factor investing targets traits linked to long run returns, such as value, momentum and quality. Learn the main factors, the evidence and how they are traded.
- Related: [Liquidity Factor](https://learn.tradelabsai.com/research/liquidity-factor/): The liquidity factor captures the extra return investors demand for holding hard to trade assets. Learn how illiquidity is measured, the evidence and its risks.
- Related: [Value Factor](https://learn.tradelabsai.com/research/value-factor/): The value factor buys cheap stocks and avoids expensive ones using ratios like book to market. Learn the evidence, the long drawdown and how to build it.
- Related: [Portfolio and Multi-Asset Backtesting](https://learn.tradelabsai.com/research/portfolio-backtesting/): Portfolio backtests simulate many positions with capital limits, sizing and rebalancing. Learn the key design choices, constraints, metrics and pitfalls.