Swedroe: Size Factor Not Dead

As director of research for Buckingham Strategic Wealth and The BAM Alliance, I’m often asked after any asset class, or factor, experiences a period of poor performance if the historical outperformance of stocks with that characteristic has disappeared because the premium has become well-known and arbitraged away.

In May, I addressed the issue of the “disappearing” value premium. Today I will look at the size premium. (Note: I also addressed the size premium in a June article.)

The size premium’s relatively poor performance in U.S. stocks over the seven-year period from 2011 through 2017 caused many investors to question its persistence. Using Fama-French data, the annual premium was negative in five of the seven years, with returns of -6.0%, -1.2%, +7.3%, -8.0%, -3.9%, +6.6% and -4.8%, respectively. The annualized premium over that period was negative 1.4%.

When asked to address this type question, the first thing I generally point out is that all factors, including market beta, have gone through—and likely will continue to go through—very long periods of negative premiums. That must be the case, or there would be no risk when investing in them, and efficient markets would arbitrage away any premium.

Supporting Evidence

The following table shows the odds of a negative premium, expressed as a percentage of the three Fama-French factors of market beta, size and value. Data is from the Fama/French Data Library, and the period is 1927 through 2017.

As you can see, at even 20 years, the equity premium was negative in 3% of periods. For the size premium, the most recent seven-year period certainly isn’t unusual, as it was negative in almost one-quarter of even 10-year periods.

The lesson here is that if you are considering investing in any factor, you should be prepared to endure long periods of negative premiums and understand the importance of staying disciplined.

One reason investors fail to earn market returns is that they lose discipline, which is why Warren Buffett—recognizing that once you have ordinary intelligence, temperament is more important than intellect when it comes to investing—has stated that investing is simple, but not easy.

There’s another point worth noting, and it demonstrates the importance of diversification. While the U.S. size premium was a negative 1.4% during the aforementioned seven-year period ending in 2017, the international size premium was actually positive at 1.8%.

Again, using Fama-French data, the international size premium was 7.8% in 2015, 5.7% in 2016 and 4.8% in 2017. If the size premium in the U.S. had disappeared because it was well-known, one might think it would also have disappeared in the rest of the developed world.

Dramatic Turnaround

It’s also worth noting that the first half of 2018 saw a dramatic turnaround for U.S. small-cap stocks. For example, using Morningstar data, through June 30, the iShares Core S&P Small Cap ETF (IJR) returned 9.4% (on a NAV basis), outperforming the S&P 500 Index, which returned 2.7%. This six-month outperformance has resulted in IJR outperforming the S&P 500 Index not just year-to-date, but also over the one-year, three-year, five-year, 10-year and 15-year periods.

We can also look at the size premium in international developed markets through the performance of passively managed, structured portfolios. Using data from Morningstar, the Dimensional Fund Advisors International Small Company Portfolio (DFISX) has outperformed the MSCI All Country ex-U.S. Index over each of the just-mentioned periods through 15 years.

We can look at the data in emerging markets as well. Once again using data from Morningstar, the Dimensional Emerging Markets Small Cap Portfolio (DEMSX) underperformed the MSCI Emerging Markets Index year-to-date (by 1.2 percentage points) and over the one-year period (by just 0.5 percentage points), but outperformed over the longer periods. (Full disclosure: My firm, Buckingham Strategic Wealth, recommends Dimensional funds in constructing client portfolios.)

It appears the rumors of the death of the size premium are greatly exaggerated.

Why Size Premium Should Persist

In “Your Complete Guide to Factor-Based Investing,” my co-author Andrew Berkin and I provide five criteria a factor must meet before you should consider allocating assets to it. We established the criteria to minimize, if not eliminate, the risk of a finding being the result of data mining. The five criteria are that a factor is persistent across very long periods, pervasive around the globe (and, where appropriate, across asset classes), robust (to various definitions), implementable (survives transaction costs) and intuitive. The size premium meets all the criteria.

I’ll briefly summarize the findings presented in the book, providing intuitive, risk-based explanations for believing the premium should persist (risk cannot be arbitraged away).

Relative to large companies, small companies typically are characterized by:

• greater leverage
• a smaller capital base, reducing their ability to deal with economic adversity
• greater vulnerability to variations in credit conditions due to more restrictive access to capital
• about 50% greater price volatility (about 30% versus about 20%)
• higher volatility of earnings
• lower levels of profitability
• a premium positively correlated with economic cycles—the risk of small stocks tends to show up in bad times, and assets that perform poorly in bad times require risk premiums
• greater uncertainty of cash flow
• less liquidity, which therefore makes their stocks more expensive to trade

Other explanations might include:

• a less-proven, or even unproven, track record for the business model
• less depth of management

Furthermore, small-cap stocks are more volatile than large-cap stocks.

Summary

One of the more common mistakes investors make is to believe that research publicizing the existence of a premium will eliminate it. The best demonstration of this point is that the equity risk premium (ERP)—the annual average return to the market beta factor—is certainly well-known. Yet no one believes that it should disappear. The simple explanation is that there are risk-based explanations for it to persist, and risk cannot be arbitraged away.

That said, all premiums are subject to potential shrinkage post-publication. They can shrink as more investors become aware of the factor and desire exposure to it, being willing to accept the risks. Alternatively, they can shrink because risks mitigate.

For example, it’s logical that the ERP is lower today because economic volatility is much lower than it was 100 years ago. Another rational for a lower ERP is that implementation costs (fund expenses, commissions, bid/offer spreads) are lower, allowing investors to capture more of the premium. Thus, they should be willing to pay a higher price for exposure to market beta.

These same two explanations apply to the size premium. It is for these reasons that, when the investment policy committee at Buckingham Strategic Wealth estimates returns for use in Monte Carlo simulations, while we use current valuations to estimate the ERP, we give historical factor premiums a 25% haircut.

ERP Unquestioned

Finally, I find it interesting that, while so many investors have questioned the persistence of the value premium because it has produced a small negative premium in the U.S. for the last 10 calendar years (about 1%, though it outperformed over the same period internationally by a greater amount) and the persistence of the size premium because of a relatively small negative premium over the prior seven years, no one questions the ERP. This is despite the fact that Ken French’s data shows that over the nine-year period ending March 2009, market beta produced an annual premium of -4.8% and an annualized premium of -7.5%.

To repeat, investors must expect that any risk-based factor will experience long periods of underperformance. That’s not a reason to avoid exposure to a factor. Instead, the right way to think about this issue is that the prudent strategy is to diversify across factors so that your risks are not concentrated in the one that happens to go through an extended period of poor performance. That’s especially true as you approach and enter retirement, when the order of returns matters a great deal.

For those interested in learning more about this concept and the benefits of diversifying across factors, I recommend reading the 2018 edition of “Reducing the Risk of Black Swans.”

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