Risk-Based Explanations of the Size and Value Premiums

January 03, 2007

Swedroe examines the literature on the source of the small/value premium, and shows why it might put your financial strategy at risk.

Few objectives ever stirred explorers more than the search for the source of the Nile. In recent years there has been the financial equivalent of that hunt. While Eugene Fama and Kenneth French's paper, "The Cross-section of Expected Stock Returns,"1 has been the benchmark model for risk adjustment since its publication in the Journal of Finance in June 1992, financial economists have been trying to discover the sources of the size (the returns of small caps minus the returns of large caps) and value (the returns of value stocks minus the returns of growth stocks) premiums. While the authors argued that the size and value factors were proxies for risk, they acknowledged that they had not identified the risk factors that could explain the premiums.

The paper, "Yield Spreads as Alternative Risk Factors for Size and Book-to-Market," 2 sought to determine if the macroeconomic variables of default spread (the spread between the yield on seasoned Baa-rated corporate bonds and the yield on ten-year Treasury notes) and term spread (the spread between one-year and ten-year Treasuries) were alternative proxies for the size and value factors.1 The period covered by their study was July 1963 to June 2001.

The authors hypothesized that since small firms tend to have limited access to external capital markets they are more vulnerable to variations in credit market conditions over the business cycle. Thus, if credit spreads widened (narrowed) we could expect lower (higher) returns to small firms.  

They also hypothesized that since high book-to-market firms were more highly leveraged, rising (declining) interest rates would have a negative (positive) effect on value stocks. And since rising (declining) interest rates correlate to a narrowing (widening) of the term spread, we should expect a narrowing (widening) of the term spread to be accompanied by lower (higher) returns to value stocks.

To summarize, small and value companies are more vulnerable to worsening credit market conditions and higher interest rates. Thus default and term spreads should be good proxies for capturing the cross-sectional pattern of returns in size and book-to-market.

Their findings can be summarizing as follows: Higher stock returns to small and value stocks are systematically related to business cycle fluctuations as indicated by the macroeconomic variables of default and term spreads. This supports the view that the higher returns to small and value stocks are compensation for risks not explained by beta (exposure to market risk).

The paper "Do the Fama-French Factors Proxy for Innovations in Predictive Variables?" came to the same conclusions.2 The author found that value (and small) companies tend to be firms under distress, with high leverage and high uncertainty of cash flow. Therefore, shocks to the default spread explain the cross-section of returns and is consistent with value being a measure of distress risk. In addition, growth stocks are high-duration assets (much of their value comes from expected future growth), making them similar to long bonds. Value stocks are low-duration assets, making them more similar to short-term bonds. Thus, shocks to the term spread (the difference between short-term bonds and long-term bonds) also explain the cross-section of returns and are also consistent with value being a measure of distress risk.     

Moon K. Kim and David A Burnie also examined the relationship between firm size and performance across the economic cycle. They found that small companies grow faster than large companies in good economic times (they are less risky) but do poorly in the worst of times (their risk shows up, frequently ending in bankruptcy). Thus it is logical that the size premium should vary across economic cycles. They concluded that the size effect is really compensation for economic cycle risk.3

There are two other similar studies worth mentioning. The study "Monetary Policy and the Cross-Section of Expected Returns," also examined the relationship between economic cycle risk and the size, as well as the value, effect. The authors used monetary policy as the variable determining economic cycle risk.4 They used three different measures of monetary policy:

·       Changes in the discount rate: an increase would be viewed as a contraction of monetary policy and a decrease as an expansion.

·       Changes in the Fed funds rate: an increase would be viewed as a contraction of monetary policy and a decrease as an expansion.

·       Interpretation of the minutes of the Federal Reserve Board meetings.

The authors found that all three measures resulted in the same conclusions in regard to the size effect:

·       When size is isolated there is a significant small firm premium only in periods of expansionary monetary policy. (Easy monetary policy is associated with falling interest rates and widening of the term spread.)

·       In restrictive periods the small effect is not statistically significant.

They came to similar conclusions regarding the value effect:

·       There is a significant value premium in expansionary periods.

·       The premium is smaller in restrictive periods, but it still is statistically significant.

The authors concluded that monetary policy has a significant impact on the size and value effects (risk and return). Good economic times generally occur when the Fed is either expansionist in its policy or simply "leaning against the wind," and bad times occur when the Fed is being restrictive in its policy. The authors also noted that since small and value firms are typically highly leveraged, they are more negatively impacted in their ability to access capital during periods of restrictive monetary policy. Thus small and value firms are more susceptible to distress in times of restrictive monetary policy (weak economy).

Summary

As a body of work, these studies all support the hypothesis that the size and value effects are premiums related to the risk of distress. Unfortunately, there is no evidence of a persistent ability to forecast changes in either economic conditions or monetary policy in a manner that leads to abnormal trading profits. This does not mean, however, that the information has no value. Understanding the source or nature of risk premiums is of great value in helping to determine the appropriate asset allocation (amount of exposure to the value and size effects). Those investors with a high correlation of their earned income (either due to their profession or their ownership of a business) to the economic cycle should consider limiting their exposure to small and value stocks (due to the high correlation of the two risks). Those with low correlation of their earned income may be more willing to seek the greater expected returns associated with small and value companies.

       

1.      Fama, Eugene and Kenneth French, "The Cross-Section of Expected Stock Returns," Journal of Finance, v.47, i.2. pp. 427-465.

2.      Hahn, Jaehoon and Hangyong Lee, "Yield Spreads as Alternative Factors For Size and Book-To Market," Journal of Financial and Quantitative Analysis, Forthcoming.

3.      Ralitsa Petkova, "Do the Fama-French Factors Proxy for Innovations in Predictive Variables?" Journal of Finance (April 2006).

4.      Moon K. Kim and David A Burnie, "The Firm Size Effect and the Economic Cycle," Journal of Financial Research, Spring 2002. 

5.      Gerald R. Jensen and Jeffrey M. Mercer, "Monetary Policy and the Cross-Section of Expected Returns," Journal of Financial Research, Spring 2002.

 


Larry Swedroe is the author of "The Only Guide To A Winning Investment Strategy You Will Ever Need," "What Wall Street Doesn't Want You to Know,"  "Rational Investing In Irrational Times, How to Avoid the Costly Mistakes Even Smart People Make Today," and " The Successful Investor Today: 14 Simple Truths You Must Know When You Invest," and co-author of "The Only Guide to a Winning Bond Strategy You'll Ever Need (January 2006). Larry is also the Director of Research for and a Principal of both Buckingham Asset Management, Inc. and BAM Advisor Services LLC in St. Louis, Missouri. However, his opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management or BAM Advisor Services.

 

Find your next ETF

Reset All