AQR Attacked the Size Factor. Scientific Beta Is Hitting Back.

The latest salvo in the world’s nerdiest fight.

Illustration by II

Illustration by II

A debate is raging on in the factor investing community, where quants are sparring over size — specifically, the size factor, a premium that investors are supposed to earn from tilting portfolios toward small-cap stocks.

Recently, quantitative investment firms including AQR and Robeco have come out with new research showing that the size factor, by itself, has not actually produced higher risk-adjusted returns.

Now Scientific Beta has come out with a defense of the size factor, with the smart beta index firm’s researchers arguing that multi-factor portfolios would perform worse if the size factor were excluded.

“On the one hand, the standalone outperformance of small stocks over large stocks is weak and may even disappear when taking exposure to the market factor into account,” Scientific Beta researchers Felix Goltz and Ben Luyten wrote in a note this month. “On the other hand, further analysis consistently shows that a size effect is found when controlling for other factors.”

For example, AQR researchers have found a “much stronger and more stable” size premium after accounting for the fact that small-cap stocks, on average, are lower quality than larger stocks. More recently, however, AQR co-founder Cliff Asness has reiterated his firm’s stance that while there may be a “decidedly non-simple size effect” from incorporating quality, there is no “simple” size premium.

“Size doesn’t really work alone,” Asness wrote in a September blog post analyzing the size factor’s performance net of market exposure. “Small firms indeed look much more impressive than large ones if you also adjust for their lower quality (not generally what people have called the small firm effect!)”

[II Deep Dive: Quants Find No Premium From Small Stocks]

In the new Scientific Beta note, Goltz and Luyten take issue with the AQR analysis, arguing that factors should be assessed from a total-portfolio perspective. Acknowledging that the size factor may not produce “stellar returns” by itself, they argued that it is still a “valuable addition” to factor-weighted portfolios.

Citing a 2019 Scientific Beta study, Goltz and Luyten showed that tilting portfolios toward small stocks improved the overall risk and returns of a multi-factor portfolio — and that decreasing the size exposure would lower the Sharpe ratio.

“Size is a strong diversifier of other traditional factors and consequently adds value to a multi-factor portfolio,” Goltz and Luyten wrote. “Analysis that fails to take exposures to factors such as momentum or profitability into account is of little practical relevance to investors.”