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Finding the small cap premium in a multi-factor world

Finding the small cap premium in a multi-factor world

By: Tom Goodwin, Sr. Research Director

The small cap equity premium that results from the size factor of a company has long been a staple of equity investing. The notion that “smaller firms have had higher risk-adjusted returns, on average, than larger firms” was first reported in the early 1980s.[1] More recently however, confronted with a “factor zoo” — to use professor John Cochrane of Chicago University’s phrase[2] — skeptics are questioning whether the small cap premium still exists or ever existed at all. 

It’s an important issue to investors, so I would like to examine these arguments and counter with other evidence supporting the theory that the small cap premium is indeed alive and well — if you know where to look.

To be or not to be?

It is certainly true that small company stocks have struggled recently in most markets. Since the bottom of the bear market in February 2009 the small cap universe as measured by the Russell 2000 Index has underperformed the large cap universe as measured by the Russell 1000 Index by an annualized 1.17% through February 29, 2016.

While it should be expected that all factors have cycles in which they underperform, some have taken the stance that this cycle of underperformance is evidence that the size premium has either disappeared or was never there to begin with.

Some say that the size premium was simply a liquidity premium in disguise and is now gone as small cap stocks have become more liquid. Others think that the size premium was an illusion caused by the inadequate treatment of delisted stocks. Finally, some believe the increase in the number of small cap funds has crowded out the size premium.[3]

We beg to differ

But new research addresses the doubters with a multi-factor model that shows how analyzing the interaction of the size factor with other factors is critical when seeking the size premium.[4] With this interaction factored in, the size premium emerges strongly in the higher quality, lower volatility corner of the small cap universe. 

This research got us to thinking about our own indexes that have been constructed with multi-factor tilts. The Russell 2000 Defensive Index was designed with a tilt toward a combination of high quality and low volatility factors within the small cap universe. We decided to see if we could find support for the results of this new research using our indexes.

It does exist!

The research using the FTSE Russell indexes does indeed support the previous findings.[5] Using factor models we found that the interaction of quality and volatility combined in the Russell 2000 Defensive Index brought out the size premium in strength. This is illustrated most simply in the chart below (Fig. 1).

The difference between the Russell 2000 Defensive and the Russell 1000 Defensive indexes is especially suggestive of a small cap premium as both indexes have quality and volatility factor tilts – the only difference being size. Contrast this with the lack of difference between the Russell 2000 and the Russell 1000 indexes, which are all-inclusive, containing no additional factor tilts.

The interaction of various factors can produce both surprises and new opportunities. Our research not only supports the existence of the small cap premium, but provides further evidence of the potential benefits of using a multi-factor framework.

Fig. 1: FTSE Russell Indexes Performance (June 1996 - September 2015)

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[1] Banz, R., “The Relationship between Market Value and Return of Common stocks,” Journal of Financial Economics, 1981

[2] http://www.nber.org/papers/w16972.pdf

[3] These arguments are made in A. Bryan (2014) “Does the Small-Cap Premium Even Exist?” Morningstar and V. Kalesnik and N. Beck (2014), “Busting the Myth About Size.” Research Affiliates.

[4] C. Asness, A . Frazzini, R. Israel, T. Moskowitz, and L. Pedersen (2015) “Size Matters, If You Control Your Junk” AQR.

[5] “Getting Defensive About the Small Cap Premium” FTSE Russell Research (2016). 


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