Settling the Size Matter

Abstract

The size premium has failed to materialize since its discovery almost 40 years ago, but is seemingly revived when controlling for quality-versus-junk exposures. This article aims to resolve whether there exists a distinct size premium that can be captured in reality. For the United States, the authors confirm that a highly significant alpha emerges in regressions of size on quality, but for international markets, they find that the size premium remains statistically indistinguishable from zero. Moreover, the US size premium appears to be beyond the practical reach of investors because the alpha that is observed ex post in regressions cannot be captured by controlling for quality exposures ex ante. The authors also find that the significant regression alpha in the United States is entirely driven by the short side of quality. Altogether, these results imply that size only adds value in conjunction with a short position in US junk stocks. However, the authors also show that small-cap exposure is vital for unlocking the full potential of other factors, such as value and momentum. They conclude that size is weak as a stand-alone factor, but a powerful catalyst for other factors.

TOPICS: Analysis of individual factors/risk premia, factor-based models, portfolio construction

Key Findings

• ▪ The size premium in the United States becomes significant in regressions that control for quality versus junk, but for international markets, it remains small and insignificant.

• ▪ The US size premium appears to be beyond the reach of investors because it cannot be captured by controlling for quality-versus-junk exposures ex ante.

• ▪ Size is weak as a stand-alone factor but a vital catalyst for unlocking the full potential of other factors, such as value and momentum.