The Size Effect in Value and Momentum Factors: Implications for the Cross-Section of International Stock Returns

Abstract

We propose and test multifactor models that break the conventional value and momentum factors on the basis of firm size and build separate factors comprised of small stocks, which we call “small-stock value and momentum factors”, and big stocks, which we call “big-stock value and momentum factors.” Our augmented models with both small-stock and big-stock factors explain a significant part of common variation in international stock returns and outperform standard benchmark models for local and global test assets both in- and out-of-sample. Small-stock factors are the key driver of this outperformance. Our results indicate the presence of funding liquidity risks related to the profitability of small firms and have important implications for asset allocation decisions in view of the increasing role of small-cap stocks as a vehicle for international diversification.