From AQR Capital Management, Jan. 23, 2015:
Does size matter? Certainly in financial markets, many researchers have questioned whether it does. In a new paper, we resurrect the size premium and restore it to its proper place alongside such stalwarts as value and momentum in terms of its efficacy and robustness. After so many years of intensive research questioning the efficacy of the size effect, that it can be emphatically revived may seem a bit far-fetched. So, how can it be that size does indeed still matter? I’ll get to that, but first a little background.Also at AQR:
The idea of earning a premium for investing in smaller companies has been around since at least the early 1980s, and likely even earlier. Over this time, the small-cap, or size, effect has become an important consideration for investors. It forms a key ingredient for pricing stocks by way of factor models, determines in part how funds are categorized, and of course led to the introduction and widespread use of small-cap funds.
But actually finding, capturing and even measuring, the size premium — as distinct from the market — has, for almost as long a time, presented a challenge for investors and researchers. Since its discovery, the size effect has come under heavy scrutiny, being challenged on many fronts. Many observe the historical record of the small-cap effect being weaker and more sporadic than other effects, such as value and momentum, for instance. More notably, size has had an extended weak period in the U.S. after it was documented and published, and has since been even weaker internationally, suffering from long periods of poor performance, and being concentrated in extreme, less-liquid microcap stocks, with nearly all of the evidence of a size premium being concentrated in a single month, January.
These assaults have rendered the pure small-cap premium as marginally significant, at best, and “not real” at worst.
But, of course, this is where our story gets interesting.
The answer to “Is there a size premium?” lies in measuring stock quality, or its opposite, “junk.” As defined in our earlier working paper, junk companies have poor profitability, stagnant growth, high risk and low payouts to investors. Junk stocks unsurprisingly trade at a discount while their high-quality counterparts — those firms that are profitable, growing, low risk and have high payouts to investors — as expected command a premium. The perhaps surprising result is that despite this discount and premium in pricing, quality stocks strongly and significantly outperform junk stocks. In our paper, we introduced the concept of a Quality-Minus-Junk (QMJ) factor that captured this phenomenon.
The many formidable challenges to size all disappear with the introduction of the QMJ factor. It turns out that small stocks are quite “junky” versus their larger counterparts, and it is this exposure that is dampening their performance. Once you account for the QMJ exposure a large and significant size premium re-emerges. We use a standard asset-pricing model that includes the market, the market lagged by one month (to account for potential lags in pricing smaller, less-liquid stocks), value, momentum, and our new factor, QMJ. We also conduct robustness checks using other measures of quality besides those defined in the QMJ factor, such as credit ratings on a firm’s debt....MORE
Size Matters If You Control Your Junk
Previously on the small stock anomaly:
It's Anomalous: "Fact, Fiction and Momentum Investing"
Whoa! Has The Small-Cap Premium Disappeared? That Would Leave Only Momentum in the Tried-and-True Anomaly File!
The Small Stock Anomaly Or Why Ken Fisher is a Marketer
Anomalies: Can Momentum Be Arbitraged Away?
and many more.
