Financial research has uncovered many relationships between investment factors and security returns. As director of research for Buckingham Strategic Wealth and The BAM Alliance, one of the most-asked questions I receive is whether such relationships will continue after that research has been published. Said another way, if everyone knows about a factor premium, should we expect it to continue outside of the sample period?
In 1981, Rolf Banz’s “The Relationship Between Return and Market Value of Common Stocks” concluded that market beta doesn’t fully explain the higher average return of small stocks. Banz found that from July 1926 through 1981, the monthly size premium averaged 30 basis points.
However, post-publication, from January 1982 through December 2017, the monthly premium has averaged just 8 basis points. Skeptics note that when we look at annualized (compound) returns, the data looks even worse. For example, some have pointed out that from 1982 through 2017, while the large-cap Russell 1000 Index returned 11.7%, the small-cap Russell 2000 Index returned just 10.6%. Thus, the size premium has been called into question, and some investors wonder whether it has shrunk or even disappeared.
Today it’s much easier and less costly to diversify the risks of small-cap stocks through mutual funds and ETFs than it was during the period Banz studied. In addition, trading costs, in the form of both commissions and bid/offer spreads, have come way down. Thus, there are logical arguments for why the size premium may have diminished over time.
The size premium issue is complicated by the well-known anomaly that, even though small value stocks have indeed provided higher returns than large value stocks, small growth stocks have provided lower returns than large growth stocks. Using the Fama-French research indexes, from July 1926 through November 2017, the annualized returns for the four asset classes are:
- Small value: 14.8%
- Large value: 12.1%
- Large growth: 9.8%
- Small growth: 8.7%
While producing lower annualized returns than large growth stocks, small growth stocks also exhibited higher volatility—the annualized standard deviation of returns was 18.3% for large growth and 26.0% for small growth. Note that the standard deviations for large value and small value were 24.7% and 28.2%, respectively.
From the viewpoint of traditional finance, while the returns and volatility of large growth, large value and small value stocks line up as they should (higher returns are positively correlated with higher volatility), the returns and volatility of small growth stocks do not. This is why small growth stocks have been referred to as the “black hole” of investing—and they present an anomaly.
The field of behavioral finance provides us with an explanation for the anomaly. It exists because investors have a preference for “lottery tickets.” Nicholas Barberis and Ming Huang, authors of the NBER working paper “Stocks as Lotteries: The Implications of Probability Weighting for Security Prices,” found that:
- Investors have a preference for securities that exhibit positive skewness (values to the right of, or more than, the mean are fewer but farther from it than values to the left of, or less than, the mean). Such investments provide the small chance of a huge payoff (winning the lottery). Investors find this small possibility attractive. The result is that positively skewed securities tend to be “overpriced”—they earn negative average excess returns.
- The preference for positively skewed assets explains the existence of several anomalies (deviations from the norm) to the efficient market hypothesis, including the low average return on IPOs, private equity and distressed stocks, despite their high risks.
In theory, we would expect anomalies to be arbitraged away by investors who don’t have a preference for positive skewness. They should be willing to accept the risks of a large loss for the higher expected return that shorting overvalued assets can provide. However, in the real world, anomalies can persist because of limits to arbitrage.
First, many institutional investors, such as pension plans, endowments and mutual funds, are prohibited by their charters from taking short positions.
Second, the cost of borrowing a stock in order to short it can be expensive, and there can be a limited supply available to short.
Third, investors tend to be unwilling to accept the risks of shorting because of the potential for unlimited losses—prospect theory at work, with the pain of a loss being much larger than the joy of an equal gain.
Fourth, short-sellers run the risk that borrowed securities will be recalled before the strategy pays off, as well as the risk that the strategy performs poorly in the short run, triggering an early liquidation. Taken together, these factors suggest that investors may be unwilling to trade against the overpricing of skewed securities. This allows the anomaly to persist.
The conclusion we can draw is that the issue of the size premium’s disappearance may be a function of this “black hole” rather than one that impacts the entire asset class—if you screened out the “black hole” stocks, there would be a size premium that could be captured. Said another way, it’s the higher-quality small-cap stocks that explain the size premium.