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As we all know, salesmen frequently tend to overstate the benefits of the products that they sell because they have a financial incentive to do so. We are constantly hearing about supposed “market beating” investment strategies. My email inbox is full of information from portfolio managers that claim to have found the holy grail of investing – more return with less risk. Unfortunately, a closer look at these strategies invariably shows that they are nothing more than short-term anomalies with no statistical evidence to support them, fantasies based on back-tested strategies that fail miserably ex-post (see Beware the Backtested Portfolio), or – in some cases – blatant dishonesty. And, of course, there is every combination of these factors.
This leads us to question the motives or misunderstandings of the seller. Are they really that naïve? Are they being dishonest? Are they incapable of doing the math and reliant upon what someone tells them to sell? Why do they blindly believe what they are told? Why don’t they apply critical thinking and question what’s being asserted? Maybe they just don’t really want to know – or, maybe this what you get when you don’t apply a fiduciary standard to investment advice.
This reminds us that we need to be cautious about our own beliefs. They need to be questioned and they need to hold up to scrutiny. We take pride in basing our advice on rigorous academic evidence. But, we also know that new research can drastically alter the landscape and that we need to consider it. Recently, there have been a series of publications that have questioned the size premium – the belief that stocks of smaller companies produce higher average returns than those of large companies. Some studies have gone so far as to suggest that there really is no small cap effect – and there never was. Obviously, since a tilt toward small cap stocks and value stocks is a key part of our investment philosophy, it’s important that we examine this research.
Rolf Banz documented the existence of the size premium in his dissertation published in 1981. Banz used data from 1927 through 1981 and found that average returns increased monotonically as company size decreased. Fama and French found a similar relation in their 1992 publication while examining data from 1963 through 1990. However, in the period of time after the publication of the Banz study, the relationship between size and return has been flatter than in the earlier period. This has led some researchers to question the continued existence of the effect.
Some have claimed that it is simply an anomaly that has disappeared as it has become known and investors have attempted to exploit it. The concern is valid, but the conclusion that the premium has disappeared is not. Anomalous patterns do tend to be traded away after being publicized. But, compensation for bearing additional risk does not. Small cap stocks are measurably more volatile and linked to both systematic default and business cycle risk, so the market demands additional compensation for bearing this risk.
Further review of the research shows that there is an explanation for the change in small cap stock behavior. In the earlier time period, the size premium existed across all small cap stocks regardless of valuation. In later time periods, the data clearly shows that the size premium remains quite significant for small neutral and small value stocks, but the relation is reversed for small growth stocks. So, the supposed disappearance of the small cap premium is really nothing more than the underperformance of small cap growth. Incidentally, this is completely consistent with what we find in large cap stocks – value outperforms growth.
There is a very simple way to adjust portfolio construction to take this into consideration – eliminate exposure to small cap growth stocks, particularly at the extremes. We rely on Dimensional Fund Advisors (DFA) to provide cost-effective and highly diversified small cap exposure in our portfolio construction. As you might expect based on their reputation for research driven solutions, DFA recognized the issue with small cap growth stocks last year and excluded them from their small cap portfolios.