A three-part column examines the much-talked-about small-cap premium.
[Editor's Note: This blog is the first of a three-part series IndexUniverse is publishing this week. Today's installment will be followed by columns on Wednesday and Friday.]
There has been some recent discussion calling into question the existence of the size premium. With that in mind, I thought it worth taking an in-depth look at the issue. The first of my three installments will start with the beginning of the small-cap premium research. Before we start, I ask that you keep the following quote from Mark Twain in mind: "The rumors of my death have been greatly exaggerated." Its relevance will become apparent as the data are explored.
The original research on the small-cap premium was done by Rolf Banz. Banz's paper was published in 1981. Among his findings was: "The results show that, in the 1936-1975 period, the common stock of small firms had, on average, higher risk-adjusted [emphasis mine] returns than the common stock of larger firms."
Professors Eugene Fama and Kenneth French looked at the evidence in their famous 1992 paper, "The Cross-Section of Expected Stock Returns." Their study covered the period 1963-1990. Their findings were different from Banz's. While they did find that small stocks had higher average returns, they believed the higher returns were compensation for risk, citing several papers that provided risk-based explanations. They certainly didn't state and—to my knowledge, have never stated—that small stocks provided higher risk-adjusted returns.
A close look at the data provides us with some interesting insights. The table below presents the data for the period covered by the Fama-French study (1963-1990), as well as the prior and succeeding periods, and the full period 1927-2012. Large stocks are represented by the Center for Research in Security Prices at the University of Chicago (CRSP) 1-5 Index (deciles 1-5); small stocks are represented by the CRSP 6-10 Index. The table presents the annualized returns.
Annualized Returns (%)
|CRSP 1-5 (A)||9.22||10.15||9.33||9.55|
|CRSP 6-10 (B)||10.41||12.30||12.43||11.54|
As you can see, small stocks outperformed large stocks over the full period, as well as each of the subperiods. In fact, not only hasn't the outperformance of small stocks disappeared, the greatest outperformance has been in the period following the publication of the Fama-French paper. There are several more important points to cover.
In academic research, the returns to factors (such as size and value) are calculated in terms of average annual returns, not compound returns. In addition, factor (or risk factor) premiums are calculated in a different, more complex, manner. You don't simply subtract the annual average return to large stocks from the annual average return to small stocks. Instead, large and small stocks are first split into three categories: growth, neutral (or core) and value.
The calculation of the premiums is then done in the following way. You take the annual average returns of large growth, large neutral and large value, and divide the total by three. You then subtract the result from the same procedure for the three small-stock categories. This is done to try to isolate the small effect.
The table below shows the annual average returns for the same four periods we looked at earlier, as well as what is called the research premium (in this case, what is called SmB, or small minus big).