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Resurrecting the Size Premium

There have been a number of articles over the past few years claiming to refute the existence of a small-cap (or size) premium, which is the historical difference in returns between small-cap stocks and large-cap stocks. While the critiques have been somewhat varied, two common claims are that the risk-adjusted returns of small-cap stocks have been similar to large-cap stocks and that the performance of small-cap stocks has been weak in international stock markets.

The Size Premium in Growth and Value Stocks

While it’s true in aggregate that small-cap stocks have had similar risk-adjusted returns (or Sharpe Ratios) compared with large-cap stocks, a more nuanced picture emerges when we separately look at the performance of small-cap versus large-cap in growth stocks and then in value stocks. The figure below displays the difference in Sharpe Ratios comparing small-cap growth stocks with large-cap growth stocks and then comparing small-cap value stocks with large-cap value stocks.

Difference in Sharpe Ratios (Small-Cap vs. Large-Cap)

Here, we see a distinctive pattern emerge: small-cap growth stocks have had very low Sharpe Ratios compared with large-cap growth stocks, but small-cap value stocks have had very high Sharpe Ratios compared with large-cap value stocks. So, while the size premium has been nonexistent in growth stocks, it has been very strong in value stocks. This is reflected in differences in compound returns as well.

Difference in Compound Returns (Small-Cap vs. Large-Cap)

The compound returns of small-cap value stocks have been about 4.0 percent higher than large-cap value stocks and still 2.6 percent higher excluding U.S. stocks. This counters the notion that the small-cap effect has been universally weak in international markets. Further, this data shows that — within value stocks — the size premium has thrived since Eugene Fama and Kenneth French’s work was published, which runs contrary to a third common critique that the premium disappeared after it was discovered (Fama and French’s first main paper was published in 1992, so the vast majority of my data sample is after their work was published).

Small-Cap Growth

What follows from this analysis is that the main driver behind work that is critical of the small-cap premium is the historically poor performance of the small-cap growth asset class. This has been well known since Fama and French published their work, and this poor performance has clearly continued out-of-sample. More recent work indicates that a partial explanation of the poor performance of small-cap growth stocks is related to profitability. Small-cap growth companies tend to have very low profitability, and there is evidence that low-profitability companies have historically had very low stock returns. So, the critiques of the size premium might in reality be confirmation of the poor performance of low-profitability companies instead of disconfirmation of a size premium.

Jared Kizer is the director of investment strategy for the BAM ALLIANCE. See our disclosures page for more information. Follow him on Twitter.

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