From the standpoint of traditional finance, small stocks are riskier than large stocks and thus contain a risk premium, which should translate into higher expected returns.
In 1981, Rolf Banz’s study, “The Relationship Between Return and Market Value of Common Stocks,” found market beta doesn’t fully explain the higher average return of small stocks. From July 1926 through 1981, the monthly size premium averaged 30 basis points. However, from January 1982 through November 2014, the monthly premium has averaged just 10 basis points. As a result, the premium has been called into question. Has it shrunk, or even disappeared?
Today, it’s both much easier and less costly to diversify the risks of small stocks, through mutual funds and ETFs, than it was during the period Banz studied. In addition, trading costs, in the form of commissions and bid-offer spreads, have come way down. Thus, we shouldn’t be surprised that the size premium may have shrunk over time.
The size premium issue is complicated by a well-known anomaly. While small value stocks have provided higher returns than large value stocks, small growth stocks have provided lower returns than large growth stocks. Using the Fama-French research indexes, the annualized returns from July 1926 through November 2014 for each of the four asset classes are:
- Small Value: 14.9 percent
- Large Value: 12.0 percent
- Large Growth: 9.6 percent
- Small Growth: 8.7 percent
While they produced lower annualized returns than large growth stocks, small growth equities exhibited higher volatility. The annualized standard deviation of returns over this period was 18.5 percent for large growth and 26.5 percent for small growth. Note that the standard deviations for small value and large value were 24.7 percent and 28.5 percent.
Thus, from a traditional finance viewpoint, 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. Returns and volatility of small growth stocks, however, don’t. This is why small growth stocks have been referred to as the “black hole” of investing, and why they present an anomaly.
The field of behavioral finance supplies us with an explanation for this anomaly. It exists because investors seem to 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, which occurs when values to the right of (more than) the mean are fewer but farther from it than the values to the left of the mean. Such investments offer a 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,” meaning they earn negative average excess returns.
- Investors’ 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 there are 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 also be a limited supply available to short. Third, investors are unwilling to accept the risks of shorting because of the potential for unlimited losses.
This is prospect theory at work. The pain of a loss is 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 early liquidation. Together, these factors suggest that investors may be unwilling to trade against the overpricing of skewed securities, allowing the anomaly to continue.
The conclusion we can draw is that the disappearing size premium issue may be a function of this “black hole,” rather than one that impacts the asset class in its entirety. If you screened out the “black hole” stocks, there would be a size premium possible to capture. Said another way, it’s the higher-quality small stocks that explain the size premium.