Measuring the Size Effect with Capitalization-based ETFs
Posted in Size Effect
April 12, 2011
Do popular capitalization-based exchange-traded funds (ETF) confirm the existence of a reliably exploitable size effect? To investigate, we compare the difference in equally weighted returns (small minus large) for the following matched pair of small-large ETFs:
Using monthly adjusted closing prices (incorporating dividends) for these ETFs during May 2000 (the earliest month available for both) through March 2011 (131 months), we find that:
The average monthly return for IWM (IWB) over the sample period is 0.7% (0.2%), with standard deviation of monthly returns 6.1% (4.8%). The following table shows the average monthly small-minus-large return for the entire sample period and for two equal subperiods. Overall, the effect is large enough to be interesting. However, the average outperformance of small stocks concentrates in the first half of the sample.
Do outliers drive the size effect? Excluding the two relatively best (worst) months for small stocks decreases (increases) the average small-minus-large return to 0.4% (0.6%) for the entire sample period, so outliers are not decisive.
Does the January effect (see “January Effect Alive and Well?” and “Persistence of the January Effect”) drive the size effect? The average monthly small-minus-large return for the 11 Januaries, and for all non-January months, in the sample is 0.5%. In other words, Januaries are not unusual.
For a closer look, we plot the variation in small-minus-large monthly returns.
The following chart plots the monthly small-minus-large return over the entire sample period. A best-fit line suggests that any size effect has dissipated over the sample period. It is possible that the introduction of capitalization-based ETFs has made it easy for investors to pursue, and extinguish, any size-related abnormal returns.
For a different perspective, we look at annual returns.
The final chart summarizes small-minus-large returns at the annual level, showing that results vary considerably from year to year over the sample period.
In summary, evidence from simple tests of capitalization-based ETFs with available data (about 10 years) indicates a potentially interesting but perhaps disappearing size effect.
Cautions regarding findings include:
- The criteria for constructing/rebalancing the ETFs may not be suited to exploit the size effect efficiently.
- The sample is short, and may be theoretically very short for reliable measurement of a size effect. For example, the effect may have an underlying multi-year dependency on some economic factor.
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