The Size Factor

Fundamentals of Market Investing by Adam J. McKee

When you buy the market, you get some exposure to small capitalization stocks, but the effects they have on your portfolio are dwarfed by giants.  That is a shame because the small-cap stocks on average provide a premium of about 3% per year in addition to beta.  If the market return over a period was 10%, then a small cap fund would have earned around 13%.  Of course, all such statements about premia are averages over time; this may not hold true in any given short period.  The size premium is not as dependable as beta, and you may go through long periods where gains in addition to beta are scant.  As with beta, the chances of gain increase when the periods in which we invest are expanded.

Other factors can be added to the size factor to increase its potency.  As we will discuss below, there is a value premium, and categories such as “small-cap value” can perform” in excess of beta with increased regularity.  The size premium has appeared in every economy where researchers have looked for it.  Foreign stocks are an important diversifier (although they are not usually considered as a factor per se).  Foreign stocks, especially those in developed markets such as Europe, will often be offered in small-cap baskets by mutual funds in the United States.

Of course, the premium for owning small-cap stocks is due to enhanced risk.  The volatility of these stocks tends to be higher than for large caps.  The reason for this is that smaller companies are untested, so investors do not have as much confidence that they will succeed as they do with large companies that have been around for a long time.  Small caps are a space where the investor can benefit from diversity, and risk-averse investors should hold small caps as an index ETF or mutual fund.

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Last Updated: 6/25/2018

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