What Is Size Premium?
The size premium refers to the historically observed tendency for small-cap stocks to outperform large-cap stocks over extended periods. This concept is a cornerstone of factor investing, where investment strategies are designed to capture specific characteristics or "factors" that have historically been associated with higher investment returns. The size premium suggests that companies with lower market capitalization may offer greater expected returns than their larger counterparts, even after accounting for other risks.
History and Origin
The concept of the size premium gained significant academic and practical prominence following groundbreaking research in the early 1980s. One of the seminal studies was conducted by Rolf Banz in 1981, which identified that smaller firms in the U.S. equity market had, on average, higher risk-adjusted returns than larger firms. This finding challenged the prevailing Capital Asset Pricing Model (CAPM), which primarily accounted for market risk.
The size premium was further cemented as a recognized anomaly and a distinct risk factor with the development of the Fama-French three-factor model by Eugene Fama and Kenneth French in the early 1990s. Their 1993 paper, "Common Risk Factors in the Returns on Stocks and Bonds," formally incorporated size (Small Minus Big, or SMB) alongside market risk and value (High Minus Low, or HML) as key determinants of average stock returns. This academic work provided a robust framework for understanding and potentially profiting from this observed phenomenon, suggesting that the premium might be a compensation for additional risks inherent in smaller companies, such as reduced liquidity or higher financial distress potential.5 These findings raised questions for the Efficient Market Hypothesis, which posits that asset prices fully reflect all available information.
Key Takeaways
- The size premium refers to the historical tendency of small-cap stocks to outperform large-cap stocks.
- It is considered a key factor in factor investing and was formalized in the Fama-French three-factor model.
- The premium may compensate investors for increased risks associated with smaller companies, such as lower liquidity or higher volatility.
- While historically observed, the consistency and magnitude of the size premium have been subjects of ongoing debate and have varied significantly over different time periods.
- Implementing strategies to capture the size premium typically involves tilting a portfolio towards smaller companies.
Formula and Calculation
The size premium itself is not a single formula, but rather a differential return. In the context of the Fama-French three-factor model, the size factor, often referred to as "Small Minus Big" (SMB), is constructed to capture this premium.
The SMB factor represents the historical excess return of diversified portfolios of small-cap stocks over diversified portfolios of large-cap stocks. It is typically calculated as:
Where:
- ( SMB ) = The size factor (Small Minus Big)
- ( R_{Small} ) = The average return of portfolios containing small-cap stocks
- ( R_{Big} ) = The average return of portfolios containing large-cap stocks
These portfolios are usually constructed by sorting stocks based on their market capitalization (size) and then often on other characteristics like book-to-market equity to ensure broad representation. The actual implementation involves creating multiple portfolios (e.g., small growth, small neutral, small value, and similarly for big companies) and then averaging their returns to derive ( R_{Small} ) and ( R_{Big} ).
Interpreting the Size Premium
Interpreting the size premium involves understanding that it represents an excess return attributed to smaller companies. A positive size premium indicates that, on average, small-cap stocks have historically delivered higher returns than large-cap stocks. This observed outperformance is often seen as compensation for various risks inherent to smaller firms, such as their greater sensitivity to economic downturns, higher volatility, and often lower trading liquidity.
Investors and academics interpret the size premium as a potential source of additional returns that can enhance long-term investment returns. However, it is crucial to note that this premium is not constant; its magnitude and even direction can fluctuate significantly over time, sometimes leading to prolonged periods where large-cap stocks outperform.
Hypothetical Example
Consider an investor evaluating two hypothetical investment funds, Fund S and Fund L, over a decade. Fund S invests exclusively in small-cap stocks, while Fund L invests solely in large-cap stocks. Both funds are passively managed to track their respective market segments.
At the beginning of the decade, both funds have a value of $10,000.
Over the 10-year period:
- Fund S (Small-Cap) grows to $25,937.42, representing an average annual return of 10%.
- Fund L (Large-Cap) grows to $21,589.25, representing an average annual return of 8%.
To calculate the hypothetical size premium for this period, we would find the difference in their average annual returns:
Size Premium = Average Annual Return of Small-Cap Fund - Average Annual Return of Large-Cap Fund
Size Premium = 10% - 8% = 2%
In this scenario, the hypothetical size premium is 2% per year. This suggests that, over this specific decade, investors holding small-cap stocks would have earned, on average, an additional 2% per year in investment returns compared to those holding large-cap stocks. This simplified example illustrates how the size premium is a differential return between market segments based on market capitalization.
Practical Applications
The size premium has several practical applications in portfolio management and investment strategy. One primary application is in factor investing, where investors intentionally tilt their portfolios towards smaller companies to potentially enhance long-term returns. This can be achieved through dedicated small-cap mutual funds, exchange-traded funds (ETFs), or by constructing customized portfolios that overweight smaller firms.
The size factor, as represented by the Small Minus Big (SMB) component of the Fama-French three-factor model and its extensions, is also used by quantitative managers and researchers to explain and predict investment returns. By analyzing a portfolio's exposure to the size factor, investors can understand how much of their returns might be attributable to this specific characteristic.
Despite periods of underperformance, some investment firms continue to advocate for an allocation to small-cap equities, citing historical long-term data and current valuation opportunities. For instance, recent research by Russell Investments suggests that while U.S. small-cap stocks have struggled in the past decade, current market conditions, including a wide valuation gap, might indicate a potential cyclical low point and future outperformance.4 This suggests that the size premium, while not always present, remains a consideration for long-term strategic asset allocation and diversification.
Limitations and Criticisms
Despite its historical prominence, the size premium faces significant limitations and criticisms. A primary critique revolves around its inconsistent performance, particularly in recent decades. The once-robust outperformance of small-cap stocks has diminished or even disappeared over various prolonged periods, leading some to question its continued existence as a reliable factor.3
Critics argue that the initial observations of the size premium might have been influenced by data biases, such as the inclusion of micro-cap stocks with extremely high historical returns or issues related to delisting returns. Furthermore, it is debated whether the premium is truly a compensation for an undiversifiable risk (as suggested by asset pricing theory) or if it simply reflects a temporary market anomaly that is arbitraged away as more investors attempt to exploit it.
Some research suggests that when controlling for other factors, such as quality or profitability, the pure size premium is less pronounced. For example, some argue that the "small-cap effect" is more about the higher risk and lower quality of many small firms, rather than size itself.2 Additionally, the increased flow of capital into factor investing strategies could potentially dilute future premiums. Research Affiliates highlights that factor returns can substantially deviate from normal distributions, and portfolios exposed to factors may experience severe drawdowns and long periods of underperformance, underscoring the risk-adjusted returns challenges.1 The often higher volatility and lower liquidity of smaller companies also represent practical challenges and risks for investors seeking to capture this premium.
Size Premium vs. Small-cap Effect
The terms "size premium" and "small-cap effect" are often used interchangeably, referring to the same phenomenon: the tendency for smaller companies' stocks to generate higher returns than larger companies' stocks over the long term. Historically, the "small-cap effect" describes the empirical observation that small-cap stocks outperform. The "size premium" then refers to the portion of the return that is specifically attributable to this size characteristic, after accounting for broader market movements.
The primary difference, if any, often lies in the context or emphasis. "Small-cap effect" typically describes the raw empirical finding that small companies performed better. "Size premium," on the other hand, is more commonly used within the framework of factor investing and asset pricing models (like the Fama-French three-factor model) to denote a specific, measurable excess return that can be captured as a factor. While conceptually similar, the "size premium" often implies a more formalized and quantifiable component of expected return that investors might seek to exploit in their portfolios.
FAQs
What causes the size premium?
The exact causes are debated, but common explanations include that smaller companies carry higher inherent risks, such as greater susceptibility to economic downturns, less access to capital, higher bankruptcy risk, and lower liquidity. Investors are theoretically compensated for taking on these additional risks with higher expected returns.
Is the size premium still relevant today?
The relevance of the size premium is a subject of ongoing debate among financial professionals and academics. While historical data suggests its existence over very long periods, its performance has been inconsistent in recent decades, with large-cap stocks often outperforming. Some argue that it still exists when accounting for other factors like company quality, while others believe it has largely disappeared due to market efficiency and changes in market structure.
How can an investor gain exposure to the size premium?
Investors can gain exposure to the size premium by allocating a portion of their portfolio management to small-cap stocks. This is commonly done through small-cap-focused mutual funds, exchange-traded funds (ETFs), or actively managed funds that specifically target smaller companies. Some factor investing strategies are designed to systematically overweight small-cap companies.
Does investing in small-cap stocks always guarantee a size premium?
No, investing in small-cap stocks does not guarantee a size premium. The size premium is a historical observation, not a guarantee of future investment returns. There have been, and likely will be, extended periods where small-cap stocks underperform large-cap stocks. Like all investments, small-cap stocks carry risks, and their performance can be highly volatile.
How does the size premium relate to diversification?
Including small-cap stocks in a well-diversified portfolio, even in the absence of a consistent premium, can contribute to diversification. Small-cap stocks often have different return patterns and sensitivities to economic conditions than large-cap stocks, which can help smooth overall portfolio returns by reducing concentration risk. However, the decision to overweight small-caps purely for a size premium should be based on a thorough understanding of its historical behavior and current market conditions.