Blog - Investing Notes

August 27, 2008 - Measuring the Size Effect with Capitalization-based ETFs

Do popular capitalization-based exchange-traded funds (ETF) confirm the existence of a size effect? To investigate, we compare the difference in returns (small minus large) for the following pair of large-small ETFs:

iShares Russell 1000 Index (Largecap) Index (IWB)
iShares Russell 2000 (Smallcap) Index (IWM)

Using monthly adjusted closing prices (incorporating dividends) for these ETFs during June 2000 (the earliest month available for both) through July 2008, we find that:

The following table shows the average monthly size effect for the entire sample period (98 months) and for three subperiods. Overall, the effect is large enough to be interesting. However, the average outperformance of IWM is concentrated in the first half of the sample, and the average monthly performances of IWM and IWB are roughly equal over the past two years.

For a closer look, we plot the variation in monthly returns.

The following chart plots the monthly size effect over the entire sample period. Visual inspection suggests that the effect declines in magnitude and volatility. A best-fit line confirms the downtrend in magnitude. 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. Or, it may be that the sample is too short in duration for reliable measurement of size effect statistics (if, for example, the effect has some underlying multi-year dependency).

In summary, a simple test of capitalization-based ETFs with available data (about eight years) indicates a potentially interesting but disappearing size effect.

For related research, see Blog Synthesis: The Size Effect.