The following is in response to Michael Edesess’ article, The Small Cap Falsehood, which appeared last week:
Dear Editor,
While you quoted Banz as saying small caps have higher "risk adjusted" returns, it was my understanding that the Fama and French paper simply stated that three factors are better at explaining expected returns. In other words they simply proved there were separate risk factors in addition to market risk that helped explain stock returns. Their conclusion could be paraphrased "small caps and value stocks are more risky, and therefore have higher returns."
Regardless of whether I am right about the Fama and French paraphrase, would you agree with this: Small caps are more risky and therefore have higher returns in line with their increased risk (in other words, the same risk adjusted returns as large cap stocks).
Thanks,
Steve Kosoris
Michael Edesess replies:
You raise a good point. The Fama and French paper is different from the Banz paper in both its methodology and conclusions. The Banz paper concludes simply, “The results show that, in the 1936-1975 period, the common stock of small firms had, on average, higher risk-adjusted returns than the common stock of large firms.” Banz’ conclusion appears to have been based on a faulty regression.
The Fama and French paper is more complex. It shows that over the historical period they investigated, returns were strongly correlated with size and value. The conclusion in their paper is, “If asset-pricing is rational, size and BE/ME [book-to-market-value] must proxy for risk.” A paraphrase of this conclusion is actually the reverse of yours: “small caps and value stocks have higher returns, and are therefore more risky” (that is, if asset-pricing is rational).
Yes, I would agree with your statement.
