A Closer Look at Factor Investing | Size Factor

A Closer Look at Factor Investing | Size Factor

By Brent Everett

See also

The second factor that we will examine is the size factor. Small cap stocks have historically outperformed large-cap stocks. We previously discussed the criteria for determining whether a factor is viable – namely, it must demonstrate persistence and pervasiveness, be intuitive or explainable in terms of financial/behavioral economics, and be investable. Size is a well-known factor that, like value, is included in the Fama-French three-factor model.

Size is persistent. In the U.S., small cap stocks have outperformed large-cap stocks by an annualized 2.40% over the period from 1928 through 20161 and in 82% of 896 overlapping 15-year periods2. The size factor is also pervasive. In developed international markets, small stocks outperformed large stocks by an annualized 4.93% from 1970-20163. We see a similar effect in emerging markets, where small outperformed by an annualized 1.81% from 1989-20164.

The size factor can be explained by a simple risk-based observation — small cap stocks are significantly more volatile than large-cap stocks. Smaller companies are often characterized by greater leverage and more vulnerability to variations in credit conditions, a smaller capital base with higher volatility of earnings and more uncertainty surrounding cash flow.

We can examine the returns of actual small cap stock funds to answer the question of whether the small factor is investible. It is fairly obvious that small cap stocks are less liquid and more expensive to trade. However, live returns of funds from Dimensional Fund Advisors (DFA), Bridgeway and Vanguard have demonstrated the ability to match or outperform small cap stock indices, demonstrating that the premium can be reliably captured.

Thus, the size premium also meets our criteria for inclusion in client portfolios. Our preferred method of implementing small cap exposure in client portfolios is through the use of small cap funds managed by Dimensional Fund Advisors. We prefer DFA’s small cap (also known as a small company) funds due to their track record of strong and consistent factor exposure, low expense ratios and tax efficiency.


  1. Dimensional US Small Cap Index minus S&P 500 Index.
  2. Small is Dimensional US Small Cap Index. Large is S&P 500 Index.
  3. Dimensional International Small Cap Index minus MSCI World ex-USA Index (gross div).
  4. Dimensional Emerging Markets Small Cap Index minus MSCI Emerging Markets Index (gross div).
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