Dispelling 3 myths about the small-size effect in equities

As a factor, size is widely understood by equity investors and is often a feature of portfolio construction. With mega caps continuing to dominate market returns, we assess the track record of the small-size factor and dispel three myths that challenge its relevance in today’s environment.

 

Need to know The exceptional performance of the ‘magnificent seven’ US technology stocks in 2023 has challenged active equity managers The difference in performance between stocks of different market valuations was documented in the early 1980s, leading to the small-size factor being coined in academia We dispel three myths about the small-size effect and offer our views on how it impacts active management

 

A happy new year for smaller companies?

The ‘magnificent seven’ (M7) contributed to 60% of S&P 500 gains in 2023¹, making the US mega caps one of the hottest investment topics of the year. Their dominance resulted in key US and global market-capitalisation indices reaching levels of extreme concentration not observed in decades.

It was not the first time the outperformance of US large caps hit headlines. Before the M7, we saw the rise of FAANG² stocks after the Covid-19 crisis. The outperformance of mega caps always presents a challenge for discretionary managers that tend to not invest in those stocks (often due to valuation or concentration concerns, or these companies’ misalignment with their strategies) and look for opportunities elsewhere. According to J.P. Morgan³, only a quarter of active large-cap managers outperformed their benchmarks in 2023. Unsurprisingly, two-thirds beat indexes in 2022, when mega caps suffered.

The disparity in performance between stocks of different market valuations was first documented in the early 1980s. In academia, it is known as a small-size factor, which is a part of the classical three-factor Fama-French model⁴. Since its creation, the S&P 500 has underperformed its equal-weighted counterpart, which might suggest that small stocks tend to do better than large ones. Nevertheless, academics are still divided in their views on the size effect. It has been documented that this effect tends to prevail mostly in Januarys, and predominately in US stocks.

However, contrary to academic findings, January 2024 did not bring any relief to smaller companies. In this commentary, we dispel three myths about the small-size effect and offer our thoughts on its impact on active management.

 

Myth 1: only mega caps are responsible

For equity investors, the performance of M7 was the main focus of 2023 and their performance set a high bar for discretionary managers. However, the recent tendency of small-sized stocks to underperform large caps is not explained solely by the strong run of mega caps.

To illustrate this, we built a long-short portfolio that overweights smaller stocks and underweights larger stocks based on the ranking of their market valuations. Using ranks instead of levels allows us to evaluate the size effect while shifting the focus away from mega caps. To get the ‘pure’ size effect (or to isolate the small-size factor) we neutralised the portfolio from interactions with various systematic risks.

 

FIG 1. Performance of the ‘pure’ small-size factor

Reading note: the above depicts a long-short portfolio built on the universe of MSCI World index stocks with neutral exposures to GICS sectors, geographic regions and styles. Source: LOIM at February 2024. For illustrative purposes only. Past performance is not a reliable guarantee of future results.

 

As figure 1 shows, the small-size factor has been in drawdown for several years and 2023 was particularly painful. That said, we also notice how strongly the factor performed in the past. In fact, the 2000s was a golden age for small-sized stocks, which led to the rise of alternative indexation or ‘smart beta’. At that time, even a monkey portfolio – i.e. stocks chosen at random – beat the benchmark due to the natural small-size bias of any generic portfolio deviating from the index. Portfolio managers did not pay much attention to the small-size bias, and even took advantage of it. Often, favourable outcomes from backtests of various investment ideas were largely the result of small-size bias rather than the strategies themselves.

Since smaller stocks started lagging larger ones, portfolio managers have become more cautious about the small-size bias and the risks associated with it. In our portfolio construction, we have applied strict risk-budgeting on the small-size factor for five years now. Unlike discretionary managers with mandates for concentrated portfolios, our systematic and more diversified strategies enable us to limit small-size bias by keeping exposure to large caps.

 

Myth 2: factor investing is still in trouble

Surprisingly, controlling for small-size bias has not been implemented in standard indices used to benchmark the performance of systematic strategies. As a result, these indices often provide a misleading picture on the performance of this factor in general.

Figure 2 illustrates the impact of the small-size bias on the excess performance of the MSCI World Diversified Multi-Factor index, which is the common benchmark for factor performance⁵. For more than 20 years before 2019, the small-size bias contributed positively – and materially – to the outperformance of the multi-factor strategy. However, it seems to be responsible for almost all the underperformance seen during the last five years. We confirmed these conclusions by computing the performance of our implementation of traditional factors.

 

 FIG 2. MSCI World Diversified Multi-Factor index: excess-performance attribution

Source: LOIM at February 2024. For illustrative purposes only. Past performance is not a reliable guarantee of future results.

 

Myth 3: the small-size factor is dead

As mentioned previously, the recent outperformance of mega caps resulted in a level of index concentration not seen in decades. The analyst inside us believes that once a certain metrics reaches its historical highs, mean reversion is inevitable. Add the curious but rigorous mathematical fact that unless a single stock can fully dominate the market index, a more diversified portfolio⁶ will eventually outperform the market index. As active managers, this is comforting. But of course, we can never know when the M7 reign will end.

‘This time is different’ expresses an alternative view on the future of the small-size factor. The rise of passive investment is often blamed for the failure of active management to beat the index, as stock valuations become exaggerated with fewer forces correcting them. Some also claim that large companies are nowadays increasingly dominating the economic landscape, taking advantage of abundant resources at hand. This argument is probably most relevant to mega caps, which, however, did not do well in 2022 while the small-size factor was flashing red. As we discussed in dispelling the first myth, mega-cap outperformance and the behavior of the small-size factor should not be confused.

 

A hedge against extreme exuberance

As systematic portfolio managers, we tend to favour evidence, which gives us some optimism as we assess the historical context. We find the current environment similar to the dotcom bubble in the late 1990s, when small-sized stocks underperformed as well. Small-size bias in equity portfolios provided a shield against the market drawdown triggered by large-cap declines in the early 2000s.

That said, in our diversified portfolios we are naturally exposed to small-size factor (intentionally or not), while always exercising control over it. Although a small-size bias did exact a toll on our portfolios in recent years, we found other opportunities that allowed us to compensate for it.

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