As the chief research officer for Buckingham Strategic Wealth and The BAM Alliance, I’m often asked, after any asset class or factor experiences a period of poor performance, if the historical outperformance of stocks with that characteristic has disappeared because the premium has become well known and arbitraged away. The size premium’s relatively poor performance in U.S. stocks over the eight-year period from 2011 through 2018 caused many investors to question its persistence. Using Fama-French three-factor model data, the annual premium was negative in six of the eight years, with returns of -5.0 percent, -0.8 percent, +5.5 percent, -7.0 percent, -4.1 percent, +6.2 percent, -4.1 percent, and -3.1 percent, respectively. The annualized premium over that period was -1.6 percent, with a total return over the period of -12.4 percent. Its performance was similar in international markets—from 2011 through November 2018, the World ex-US Small minus Market factor was an annual average -1.3 percent. When asked to address this type of question, the first thing I generally point out is that all factors, including market beta, have gone through, and likely will continue to go through, very long periods of negative premiums. (Read Wes Gray’s post, where he suggests that it takes alien powers to take the pain of academic factor portfolios.) That must be the case, or there would be no risk when investing in them, and efficient markets would arbitrage away any premium. The following table shows the odds of a negative premium, expressed as a percentage, for the three Fama-French factors of market beta, size and value. Data is from the Fama/French Data Library and covers the period 1927 through 2017. Using the historical mean premium, the historical standard deviation of the premium, and Monte Carlo simulations, we can estimate the odds of a premium being negative in future periods. As you can see, even at 20 years, we should expect the equity premium to be negative in 3 percent of periods. (Note that most financial economists believe the equity risk premium, or ERP, will be smaller than the historical average because valuations are now much higher than average. All else being equal, that increases the odds of a negative premium over all time frames.) As you can also see, the most recent eight-year period of poor performance certainly isn’t unusual for the size premium, as it should be expected to be negative in almost one-quarter of even 10-year periods. The lesson here is that, if you are considering investing in any factor, you should be prepared to endure long periods of negative premiums and understand the importance of staying disciplined. One reason investors fail to earn market returns is that they lose discipline, which is why Warren Buffett stated that temperament is more important than intellect when it comes to
investing, and that investing is simple but not easy.
There’s another point worth noting, and it demonstrates the importance of diversification. While the annual average U.S. size premium was -1.6 percent during the eight-year period ending in 2018, the international size premium was +1.5 percent. If the size premium in the United States had disappeared because it was well known, one might think it would also have disappeared in the rest of the developed world.
effect, corrects common misconceptions, and addresses criticisms of the size premium. He shows why using a pure market factor as the sole risk factor in estimating the expected return provides an incomplete estimate.
Citing the academic literature, Grabowski offers
the following characteristics of smaller firms that cause the rate of return
investors expect when investing in stocks of small companies to be greater than
the rate of return expected when investing in stocks of large companies. These
traits provide a risk-based explanation for why the premium should persist—why
it cannot be arbitraged away:
Why the Size Premium Should PersistIn “Your Complete Guide to Factor-Based Investing,” my co-author, Andrew Berkin, and I provide five criteria a factor must meet before you should consider allocating assets to it. We established the criteria to minimize, if not eliminate, the risk of a finding being the result of data mining. The five criteria are that a factor is persistent across very long periods, pervasive around the globe (and where appropriate, across asset classes), robust (to various definitions), implementable (survives transaction costs) and intuitive. The size premium meets all the criteria. The following briefly summarizes the findings presented in the book, providing intuitive, risk-based explanations for believing the premium should persist (risk cannot be arbitraged away). Relative to large companies, small companies typically are characterized by the following:
- Greater leverage.
- A smaller capital base, reducing their ability to deal with economic adversity.
- Greater vulnerability to variations in credit conditions due to more restrictive access to capital.
- About 50 percent greater price volatility (about 30 percent versus about 20 percent).
- Higher volatility of earnings.
- Lower levels of profitability.
- A premium positively correlated with economic cycles—the risk of small stocks tends to show up in bad times, and assets that perform poorly in bad times require risk premiums.
- Greater uncertainty of cash flow.
- Less liquidity, which therefore makes their stocks more expensive to trade.
- A less proven, or even unproven, track record for the business model.
- Less depth of management.
- Potential competitors can more easily enter the “real” market (the market for the goods and/or services offered to customers) of the small firm and take the value that the small firm has built.
- Large companies have more resources to better adjust to competition and avoid distress in economic slowdowns.
- Small firms undertake less research and development and spend less on advertising than large firms do, giving them less control over product demand and potential competition. Small firms have fewer resources to fend off competition and redirect themselves after changes in the market occur.
- Smaller firms often have fewer analysts following them, and less information available about them.
- Smaller firms may have less access to capital.
- Smaller firms have thinner management depth.
- Smaller firms have a greater dependency on a few large customers.
- The stocks of smaller companies are less liquid than the stocks of their larger counterparts.
- Analysts and investors have difficulty evaluating small, little-known companies and estimating traditional quantitative risk measures for them. This ambiguity adds to the risk of investment and increases the return required to attract investors.