Practical Applications of Fact, Fiction, and the Size Effect

Abstract

Practical Applications Summary The notion that small stocks have higher average returns than large stocks, even after risk adjustment, has long been a recognized tenet of equity investing. Yet it is not supported by the evidence, according to Fact, Fiction, and the Size Effect, published in the Fall 2018 issue of The Journal of Portfolio Management. Ron Alquist, Ronen Israel and Tobias Moskowitz (all of AQR Capital Management) seek to debunk some of the popular “fictions” propounded by those arguing for the existence of a size premium, most notably its very validity as a statistically significant anomaly. In their place, the authors establish a number of “facts:” The size effect is dominated by a January seasonal effect, it can largely be attributed to an illiquidity premium, it does not apply to other geographies and asset classes, it mostly comes from microcap stocks, and it is difficult to implement in practice due to illiquidity and trading friction. Yet the size effect is not dead. A statistically significant size effect can be resurrected if small-cap indices are corrected for the quality (or profitability) factor, in effect reducing the weighting of junk stocks that tend to be more prevalent at the lower end of the capitalization spectrum.