Quants Find No Premium From Small Stocks

But tilting portfolios toward small-caps can yield other rewards, according to Robeco researchers.

Illustration by II

Illustration by II

Does the size factor actually work? The answer, according to quantitative researchers at Robeco: Not really.

The size factor, discovered in 1981, is based on the finding that small firms have higher risk-adjusted returns than large firms, according to a new paper from David Blitz, head of quant research at Robeco, and Matthias Hanauer, a member of the quant research team. Proponents of the factor argue that investors can earn a premium by tilting their portfolios toward small-cap stocks.

Just one problem: “The size premium has failed to materialize since its discovery almost forty years ago,” Blitz and Hanauer said in the paper.

In recent years, however, research has emerged suggesting that size factor actually does work, after controlling for other factors. AQR co-founder Cliff Asness and his colleagues published a paper in 2018 finding “a strong and distinct size premium” after accounting for the fact that small-cap stocks, on average, are lower quality than larger stocks. A separate paper in the Journal of Index Investing came to a similar result when controlling for the profitability factor used in the five-factor model developed by Eugene Fama and Ken French.

[II Deep Dive: Cliff Asness Knows Less than He Thought]


In their new paper, Blitz and Hanauer try “settling the size matter” once and for all by testing these new findings for themselves.

First, they confirm what AQR discovered two years earlier: “If one accounts for the quality difference between small and large stocks, a highly significant and distinct small-cap premium is, in fact, clearly present in the U.S. stock market.” But when they looked at international markets, the size premium was “economically small and statistically indistinguishable from zero,” according to the paper.

This “makes the U.S. the exception rather than the rule,” the Robeco researchers wrote.

Even in the U.S., however, “it is not obvious how this alpha could be isolated and captured with an investable strategy,” Blitz and Hanauer argued. Based on their analysis, the added value from the size factor derived entirely from a short position in “junk” stocks. The premium did not materialize when only controlling for long exposures to “quality” stocks.

“Factor investing strategies in practice typically follow a long-only approach,” they wrote. “Long-only factor strategies do not benefit from adding generic small-cap exposure.”

Despite their findings, Blitz and Hanauer argued that factor investors can still benefit from small-cap exposures, because other factor premiums “tend to be bigger among small-cap stocks than among large-cap stocks.”

“Size can add a lot of value by serving as a catalyst that helps to unlock the full potential of other factors, such as value and momentum,” they concluded. “This interaction between size and other factors may already be a sufficient reason for long-only investors to systematically overweight small-cap stocks, regardless of whether the size characteristic itself is rewarded with a premium.”