Swedroe: Size, Value & Momentum

August 12, 2013

Factor-focused investing can help returns, but the devil is in the details.

Because of both the magnitude and pervasiveness of their related premiums, there have been three factors that have dominated the financial academic literature in recent decades—size, value and momentum. The focus of the literature has been both in terms of whether markets are efficient and in explaining the cross section of returns.

It’s important to understand that the premiums related to these factors are determined by long/short portfolios. Thus, the small-cap premium is the annual average return on small-cap stocks minus the annual average return on large-cap stocks. Similarly, the value premium is the annual average return on value stocks minus the annual average return on growth stocks, and the momentum premium is the annual average return on stocks that exhibit positive momentum minus the average annual return on stocks that exhibit negative momentum.

The fact that the premiums result from long/short portfolios raises issues to which Ronen Israel and Tobias J. Moskowitz of AQR, and authors of the paper “The Role of Shorting, Firm Size, and Time on Market Anomalies,” published in the May 2013 edition of the Journal of Financial Economics, sought the answers.

They investigated three questions. First, because shorting can be expensive and many institutional investors, such as mutual funds and pension plans, are restricted to long/only portfolios, how important is short selling to the profitability of these strategies?

Second, because trading in the smallest stocks can be very expensive, and shorting them can be difficult as well as expensive, what role does firm size play in the efficacy of these investment styles?

Third, because of concerns that the premiums might disappear—or at least be impacted—after publication of academic papers providing evidence of their existence, how have the returns to these strategies and the role of size and shorting varied over time?

Their study included not only U.S. stocks, but also international stocks, government bonds, currencies and commodities futures. For U.S. stocks, the data basically cover the period 1927-2011. For the other asset classes, the period covered is February 1972 to December 2011. The following is a summary of their findings:




  • Long positions comprise the bulk of the size premium, capture about 60 percent of the value premium and comprise half of the momentum premium.
  • The value premium is concentrated primarily in small stocks, being insignificant in the largest 40 percent of NYSE stocks. This was true in all four 20-year subperiods.
  • The size effect emerges in a significant way only when considering more extreme exposure to small stocks—basically micro-cap stocks.
  • The momentum premium is present and stable across all size groups and the entire 86-year period—it was persistent in all four 20-year periods examined, including the most recent two decades that followed the initial publication of the original momentum studies.
  • Evidence across other asset classes and markets confirms the existence of value and momentum return premia.
  • There’s little evidence that size, value and momentum returns have been significantly affected by changes in trading costs or institutional and hedge fund ownership over time.
  • The premia survive reasonable estimates of trading costs—they’re not just theoretical.


What conclusions can we draw from the evidence? First, neither the publication of papers providing evidence on their existence, nor the increase in institutional ownership, has significantly impacted the size of the premiums.

Second, long-only portfolios can gain exposure to the premia, after costs. Third, investors seeking exposure to the size premium need to invest in micro-cap stocks, and accept those risks. Fourth, investors seeking exposure to the value premium need to concentrate their exposure in small value stocks.

Larry Swedroe is director of Research for the BAM Alliance, which is part of St. Louis-based Buckingham Asset Management.



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