Swedroe: A Look At Ways 3 Factors Work

There are plenty of ways and reasons the size, value and momentum factors work over time.

Three factors—size, value and momentum—have dominated the academic literature in recent decades, largely because of the magnitude and pervasiveness of their related premiums. The research literature has tended to focus on whether markets are efficient, and on attempts to explain 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 size 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 some important and fundamental issues. Ronen Israel and Tobias J. Moskowitz—authors of “The Role of Shorting, Firm Size, and Time on Market Anomalies,” which appeared in the May 2013 edition of the Journal of Financial Economics —sought to explore the circumstances surrounding them. 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, 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?

The study included not only U.S. stocks, but also international equities, government bonds, currencies and commodities futures. For U.S. stocks, the data basically covers the period from 1927 through 2011. For the other asset classes, the period covered is February 1972 to December 2011. Following is a summary of the authors’ findings:

• Long positions comprise the bulk of the size premium, capture about 60 percent of the value premium, and make up about half of the momentum premium.
• The value premium is concentrated primarily in small stocks and becomes 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 subperiods examined, including the most recent two decades following the initial publication of the original momentum studies.
• Evidence across other asset classes and markets confirms the existence of value and momentum return premiums.
• 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 premiums survive reasonable estimates of trading costs—they’re not just theoretical.

So, what conclusions can we, as investors, draw from the evidence?

• First, neither the publication of papers providing evidence of their existence, nor the increase in institutional ownership, has significantly impacted the size of the premiums in question.
• Second, long-only portfolios can gain exposure to the premiums, after costs.
• Third, investors seeking exposure to the size premium should consider investing in micro-cap stocks, and accept those risks.
• Fourth, investors seeking exposure to the value premium should consider concentrating their exposure in small value stocks.

Larry Swedroe is the director of research for the BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.