Swedroe: Book To Market & Size Premium

November 24, 2014

Looking at the value premium relative to book-to-market valuations tells us many things, but don’t try timing the size factor.e

Since the 1992 publication of “The Cross-Section of Expected Stock Returns” by Eugene Fama and Ken French, the size factor has been among those used in asset pricing models that attempt to explain the differences in returns of diversified portfolios.

While Fama and French limited their model to three factors (beta, size and value), asset pricing models since 1998 typically have included momentum as a fourth factor. In the last few years, we have seen profitability (or quality or investment) added as a fifth factor.

Recently, the size premium has been called into question, because during the last 30 years (1984-2013), the annual size premium has been just 0.9 percent. In the 57 years prior to that (1927-1983), it had been 4.2 percent.

While the existence of a size premium is supported by a wide body of literature that provides a risk-based explanation for it, one explanation offered for the premium’s decline is the publication in 1981 of Ralph Banz’s paper, “The Relationship Between Return and Market Value of Common Stocks.”

This paper made the investing public aware of the outperformance attributed to the factor. And the publication of such findings can often lead to the shrinkage, or even elimination, of a premium. Elimination can occur if there is no risk-based explanation for the premium (only a behavioral one). Shrinkage, though not elimination, may occur if a risk-based explanation remains.

Trading Costs Add Up

A further explanation for the shrinking size premium could be that trading costs for small stocks, and trading costs in general, have declined as bid-offer spreads have narrowed dramatically.

One might argue that a belief among investors in the Federal Reserve’s ability to effectively dampen the risks of economic cycles (and thus the risks of small stocks) may help account for the declining size premium, as well as a falling equity risk premium.

Yet another explanation might be that stronger and improved government regulations, such as those included in the Sarbanes-Oxley Act of 2002, have reduced risks, and thus the required premium.

A September 2014 paper, “Discount Rates, Market Frictions, and the Mystery of the Size Premium,” provided a new and interesting insight into the size premium. The study, by Thiago De Oliveira Souza, covered the period 1927-2012 for the U.S. and 1980-2011 for the
U.K.
The following is a summary of his findings:

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