Tuesday, February 28, 2017

Factors: The Problem With Small Cap Stocks (the effect probably isn't real)

I hate to argue with Fama-French, hate it hate it, hate it.
That said, I'm not sure it isn't just an artifact of the survivorship bias explained below.
Momentum is real though, for now,

From Dual Momentum:

Factor Zoo or Unicorn Ranch?
According to Morningstar, as of June 2016, the assets in smart beta exchange traded products totaled $490 billion. BlackRock forecasts smart beta using size, value, quality, momentum, and low-volatility will reach $1 trillion by 2020 and $2.4 trillion by 2025. This annual growth rate of 19% is double the growth rate of the entire ETF market. Are factors the cure-all for our investment needs? Or are they like “active management” that everyone wanted to have instead of passive index funds in the 1970s?

No one then wanted to be just average. This ironically gave many investors below average returns as they used the same information to compete against one another.  Superior performance was usually due more to luck than to skill. But Bill McNabb, CEO of Vanguard, points out that passive index funds have been in the top quartile of long-term performance.

Factor-based investors and advisors now think they have an advantage. They base this belief on the results of theoretical asset pricing models, many of which have failed empirically.

Asset pricing models look at long-term long/short returns without taking into account the price impact of trading. Factors that looked good on paper may be lacking in robustness, pervasiveness, persistence, or intuitiveness. Let us see.   

Does Size Matter?
The small cap size premium was the first identified factor. Banz wrote about it in 1981. His results were influenced by extreme outliers from the 1930s.

Looking at more recent history, the oldest small cap index is the Russell 2000. It started in January 1979. Here is the Russell 2000 annual return and volatility over the life of the index compared to the S&P 500 index.
Russell 2000 underperformed the S&P 500 by 1.3% annually and had a substantially higher standard deviation. The Russell 2000 thus  underperformed on both a risk-adjusted and non-risk adjusted basis.{1]

Here is a chart comparing the Sharpe ratios of all small and large cap stocks over a longer period of time. Small cap stocks usually failed to show significantly higher risk-adjusted profits than large cap stocks.  
In the table below long-only small caps slightly outperformed large caps globally since 1982. But small caps have underperformed large caps in the U.S. since 1926. Where is the outperformance that Banz talked about?...