The Size Effect is Not Dead

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This article originally appeared on ETF.COM here.

On July 16, 2018, at approximately 8:00pm ET, this article was edited to use the correct symbol for Dimensional's microcap fund (DFCSX). The return for that fund from 1984 to 2017 is now correctly shown as 10.98% and it is compared to the S&P 500, since VOO (the benchmark originally used in the article) has not been around since 1984. The return for the S&P 500 over that period was 11.20%.

The first major anomaly to the first formal asset-pricing model, the capital asset pricing model (CAPM), was the size effect. The size effect is the phenomenon that small-cap stocks on average outperform large-cap stocks over time. The size premium is the average annual return achieved by being long small-cap stocks and short large-cap ones.

The size effect was first documented by Rolf Banz in his 1981 paper, “The Relationship Between Return and Market Value of Common Stocks,” which was published in the Journal of Financial Economics. After the 1992 publication of Eugene Fama and Kenneth French’s paper, “The Cross-Section of Expected Stock Returns,” the size effect was incorporated into what became finance’s new workhorse asset-pricing model, the Fama-French three-factor model (adding value and size to the CAPM’s market beta).

Unfortunately, the size premium basically disappeared in the United States after the publication of Banz’s work. Using data from Dimensional Fund Advisors, from 1982 through 2017, the annual size premium in U.S. stocks was just 0.9 percent on an annual average basis and 0.0 percent on an annualized basis.

However, despite the absence of a premium to small stocks, over the same period Dimensional’s U.S. Micro-cap fund (DFCSX) returned 12.2 percent, providing a 0.6 percentage point higher return than the Vanguard 500 Index Fund (VFINX), which returned 11.6 percent. I’ll come back to that point in my summary. (Also, in the interest of full disclosure, my firm, Buckingham Strategic Wealth, recommends Dimensional funds in constructing client portfolios.)

Size needs other factors

The lack of a size premium over the past 34 years has led to much debate on the subject. Ron Alquist, Ronen Israel and Tobias Moskowitz, members of the research team at AQR Capital Management, contribute to the literature on the size effect with their May 2018 paper, “Fact, Fiction, and the Size Effect.”