A strong size premium exists in the U.S. stock market once quality characteristics are controlled for. The premium does not carry over to international markets, however.

The size factor is the phenomenon of smaller-company stocks realizing higher risk-adjusted stock than stocks of large companies. Since the size premium was first discovered for the U.S. stock market in the early 1980s it has been criticized due to its weak historical track record.

However, more recent research suggests that the inconsistency of the size effect can largely be attributed to the volatile performance of small, low-quality (“junky”) firms. Once the quality-minus-junk (QMJ) factor is controlled for, a much stronger and stable size premium emerges. Researchers from investment firm Robeco examined these latest findings regarding the size effect to determine if a strong size premium can be isolated and captured.

The study’s authors found that a distinct size premium materializes in the U.S. stock market after controlling for QMJ. For international markets, the magnitude of the estimated size premium also consistently rose once QMJ characteristics were controlled for. However, the researchers found that the size premium remains statistically insignificant for international markets.

When examining the size premium in the U.S. more closely, the study’s authors found that “the alpha observed in the regressions appears to be beyond the practical reach of investors.” Based on the authors’ analysis, the added value from the size factor is entirely derived from a short position in junk stocks. The premium did not materialize when controlling for long exposures to quality factors.

Despite these findings, the researchers argued that factor investors can still benefit from small-cap exposures. They said, “Size can add a lot of value by serving as a catalyst that helps to unlock the full potential of other factors, such as value and momentum. This interaction between size and other factors may already be a sufficient reason for long-only investors to systematically overweight small-cap stocks, regardless of whether the size characteristic itself is rewarded with a premium.”

Source: “Settling the Size Matter,” by David Blitz and Matthias X. Hanauer; SSRN, September 2020.