In addition, the authors found that “small quality stocks outperform large quality stocks and small junk stocks outperform large junk stocks, but the standard size effect suffers from a size-quality composition effect.” In other words, controlling for quality restores the size premium.
The authors thus concluded the challenges to the size premium “are dismantled when controlling for the quality, or the inverse ‘junk,’ of a firm. A significant size premium emerges, which is stable through time, robust to the specification, more consistent across seasons and markets, not concentrated in microcaps, robust to non-price based measures of size, and not captured by an illiquidity premium. Controlling for quality/junk (the QMJ factor) also explains interactions between size and other return characteristics such as value and momentum.”
Robust Size Premium
Further, Asness, Frazzini, Israel, Moskowitz and Pedersen found that “controlling for junk produces a robust size premium that is present in all time periods, with no reliably detectable differences across time from July 1957 to December 2012, in all months of the year, across all industries, across nearly two dozen international equity markets, and across five different measures of size not based on market prices.”
They also note: “When adding QMJ as a factor, not only is a very large difference in average returns between the smallest and largest size deciles observed, but, perhaps more interestingly, there is an almost perfect monotonic relationship between the size deciles and the alphas. As we move from small to big stocks, the alphas steadily decline and eventually become negative for the largest stocks.”
Another important finding from the study was that higher-quality stocks were more liquid, which has important implications for portfolio construction and implementation.
The authors found similar results when, instead of controlling for the quality factor, they controlled for the low beta factor—high-beta stocks (those lottery tickets) have very poor historical returns. High-beta stocks tend to be the same low-quality stocks. In addition, they found that small stocks have negative exposure to two relatively new factors, profitability (referred to as RMW, or robust minus weak) and investment (referred to as CMA, or conservative minus aggressive). High-profitability firms tend to outperform low-profitability ones, and low-investment firms tend to outperform high-investment ones.
In our book, “Your Complete Guide to Factor-Based Investing,” my co-author Andrew Berkin, director of research for Bridgeway Capital Management, and I offer evidence demonstrating the size premium has been persistent across time and economic regimes, pervasive around the globe, has intuitive risk-based explanations, and is implementable. While the publication of research can certainly lead to cash flows that can cause premiums to shrink, if there are risk-based explanations, the premiums should never disappear.
And while, as mentioned, there are some logical explanations for why the size premium may have shrunk (i.e., lower implementation costs), there also remain simple, intuitive, risk-based explanations for why the premium should persist. In addition, Berkin and I showed that the size premium is a unique source of risk and return, having low correlation to other common factors, such as market beta, value, momentum and quality/profitability, providing diversification benefits.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.