Swedroe: Size Factor Not Dead

July 23, 2018

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.

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