The Half-Life Of Smart Beta

October 23, 2013


The size effect is easy enough to explain to your grandmother. If small-cap or micro-cap stocks are hard to research and understand, expensive to trade and suffer from illiquidity that makes buying them expensive and can make selling them impossible, they are indeed riskier than large-cap stocks. The small-cap premium is a compensation for all these risks.

However, the size effect has largely disappeared since its discovery and the advent of small-cap mutual funds in the 1980s. In 2011, Fama and French themselves found no evidence of the size effect in any of four developed market regions between 1991 and 2010.10 Figure 2 shows the effects they tested, and whether these effects showed statistical significance at the 95 percent level. Furthermore, they believe this disparity cannot be explained by liquidity.


This makes sense in the context of product development history. Many of the former barriers to small-cap investing have disappeared. Pooled vehicles have lessened the information cost and decreased trading costs. While the size effect remains interesting to researchers, investors would be excused for a lack of interest in market cap as an avenue for outperformance.

After value investing’s 1934 debut from the pens of Graham and Dodd,11 and further refinement in a 1983 description by Basu,12 Fama and French (1993)6 also found that stocks with valuations that are cheap relative to the overall market perform better over subsequent periods than those that are expensive. Interestingly, in 2011, Fama and French modified this position, finding that the value effect (and the momentum effect) were stronger for small-caps than for large/midcaps.10 In a 2009 paper, Asness et al. disagreed, writing that “Value and momentum deliver positive expected abnormal returns in a variety of markets and asset classes.”13 In any event, the value premium is not stable year-to-year. Value can, and does, often underperform the broad market.

The value effect has been attributed to compensation for default risk, the business cycle, cash flow sensitivity, dilution risk and, again, the January effect. Recent research has attributed the value effect’s cause to investor sensitivity to cash flow variance in uncertain or choppy economic conditions.



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