The Size Premium in Equity Markets: Where Is the Risk?

Abstract

The authors find that when measured in terms of dollar-turnover, and once β and low volatility (low-vol) neutralized, the size effect is alive and well. With a long-term t-statistic of 5.1, the cold-minus-hot (CMH) anomaly is certainly not less significant than other well-known factors such as value or quality. As compared to market-cap-based SMB, the authors report that CMH portfolios are much less anti-correlated to the low-vol anomaly. In contrast with standard risk premiums, size-based portfolios are found by the authors to be virtually unskewed. In fact, they report that the extreme risk of these portfolios is dominated by the large-cap leg; small caps actually have a positive (rather than negative) skewness. The only argument that the authors find favors a risk premium interpretation at the individual stock level is that the extreme drawdowns are more frequent for small-cap/turnover stocks, even after accounting for volatility. According to the authors, however, this idiosyncratic risk is clearly diversifiable and should not, in theory, generate higher returns.

TOPICS: Security analysis and valuation, analysis of individual factors/risk premia, statistical methods