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Size



The size factor, or SMB, refers to the difference in returns between small cap stocks and large cap stocks. The size factor is typically measured using the market capitalization of a company. Small cap stocks are those with a lower market capitalization, while large cap stocks have a higher market capitalization. In general, small cap stocks tend to be more volatile and carry more risk than large cap stocks. However, they also tend to offer higher returns due to this added risk. On the other hand, large cap stocks tend to be more stable and offer lower returns but with lower risk. The size factor is often used in investment strategies as a way to adjust exposure to the risk and return tradeoff between small and large cap stocks.


The size factor, as seen in the graph below, tends to have a lower rolling volatility compared to the other style factors. On average, the long-short size factor has a 1-year rolling volatility of less than 10% during the 2010-2020 decade. The size factor has generally been a consistent performer over the last decade, with the only period of underperformance being during the tech bubble in the late 1990s.

It is worth noting that the size factor has a negative correlation with the value factor, which makes sense as value stocks tend to be larger, more established companies while smaller, riskier companies are more likely to be classified as growth stocks. The size factor also has a positive correlation with the momentum factor, which again makes sense as smaller, riskier companies are more likely to experience significant price movements and be classified as momentum stocks.


Reasons

  • Small-cap stocks have historically earned a return premium over large-cap stocks to compensate investors for taking on the higher risk associated with small cap companies

  • The size factor is based on the market capitalization (market cap) of a company, which is calculated by multiplying the number of shares outstanding by the share price

  • The size factor can be implemented through a long-short strategy, where investors go long a basket of small-cap stocks and short a basket of large-cap stocks

  • The size factor is included in the Fama-French three-factor model, which expands upon the capital asset pricing model (CAPM) by adding a value factor and a size factor in addition to the market factor

  • The size factor has consistently produced returns over time and across different equity markets, indicating its validity as a factor in investment strategies.

Alpha


The size factor is based on the concept of company size, which is measured by the market capitalization (market cap) of a company. It is calculated by multiplying the number of shares outstanding by the share price. The size factor is one of the first explanatory factors to be introduced in the capital asset pricing model (CAPM). It suggests that consistent returns can be achieved by going long a basket of small-cap stocks and shorting a basket of large-cap stocks. This is based on the assumption that small-cap stocks are inherently riskier (higher volatility and beta) than large-cap stocks and therefore should earn higher returns to compensate for this additional risk. The size factor is a major component of the Fama-French model and has historically been considered an alpha factor, but its widespread use has led to the erosion of its alpha status and it is now primarily used in risk models or for filtering and selecting an investable universe.


Illustration


The size factor is often used as part of the Fama-French model to explain returns on stocks. It has been shown to have consistent returns when investors go long a basket of small-cap stocks and short a basket of large-cap stocks. Historically, the size factor was treated as an alpha factor, but as it has become more widespread, it has become primarily used in investors' risk models or for filtering and selecting their investable universe. The volatility of the size factor is similar to the value factor, with an average rolling 1-year volatility of around 9%. However, during times of increased market volatility, such as during the COVID-19 pandemic, the volatility of the size factor may increase.




The size factor, like the value and momentum factors, has experienced a significant increase in volatility since the onset of the COVID-19 pandemic in 2020 (see above). The size factor, which is focused on small-cap stocks, has seen its 1-year rolling volatility rise from its average of around 9% to a peak of over 30%. This increase in volatility is expected to return to its pre-pandemic levels in the coming months. It is worth noting that the size factor tends to have a similar level of volatility to the value factor, with both factors experiencing similar spikes in volatility during times of market uncertainty.


Correlation


In terms of the relationship with the other style factors, the size factor is generally negatively correlated with value and momentum. This makes sense as smaller companies tend to be more risky and therefore are more likely to be classified as value or momentum stocks, which are both seen as riskier investments. However, these correlations can vary over time and may not always be present, as market conditions and investor sentiment can change. It is important to note that these correlations should not be seen as fixed and can change over time, so it is important to continuously monitor and analyze the relationships between different factors.



Correlation of the long-short size factor to other Fama-French style factors such as value (hml), size(smb) and momentum (mom), based on a 2 year lookback window



When does value do well?


It is worth noting that the size factor, like other style factors, is not a standalone strategy and should be considered as part of a diversified investment portfolio. While size may have a negative correlation with quality, it has been shown to have a positive correlation with value and momentum. This means that in some market environments, small-cap stocks may perform well while in other environments, large-cap stocks may perform better. It is important for investors to consider the interactions between different style factors and how they may affect portfolio performance.


Size factor performance against other Fama-French style factors, time period 2010-2022


Historical performance


Size, like other style factors, can be used to construct investment portfolios and can be combined with other factors to create a multi-factor portfolio. It is important to note that size is not a standalone factor and should be considered in the context of a portfolio's overall risk and return profile. Size can also be used as a risk factor in risk models to help manage and diversify portfolio risk. It is worth noting that the size factor, like other style factors, has periods of underperformance and it is important to consider the long-term performance of the factor, rather than just focusing on short-term results.




The size factor is a style factor that measures the performance of small-cap stocks versus large-cap stocks. It is based on the idea that small-cap stocks are riskier and therefore should have higher returns to compensate for that risk. The size factor has historically had relatively low volatility, similar to the value factor, with an average rolling 1-year volatility of around 9%. However, like other factors, the volatility of the size factor spiked during the COVID-19 pandemic in 2020. In terms of performance, the size factor has had a mixed history, with some years delivering strong returns and others showing negative returns. However, it is important to note that the size factor is now more commonly used as a risk factor or for universe generation rather than as a proactive alpha-generating strategy.


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