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Size Effect

Do the stocks of small firms consistently outperform those of larger companies? If so, why, and can investors/traders exploit this tendency? These blog entries relate to the size effect.

Ziemba Party Holding Presidency Strategy Update

“Exploiting the Presidential Cycle and Party in Power” summarizes strategies that hold small stocks (large stock or bonds) when Democrats (Republicans) hold the U.S. presidency. How has this strategy performed in recent years? To investigate, we consider three strategy alternatives using exchange-traded funds (ETF):

  1. D-IWM:R-SPY: hold iShares Russell 2000 (IWM) when Democrats hold the presidency and SPDR S&P 500 (SPY) when Republicans hold it.
  2. D-IWM:R-LQD: hold IWM when Democrats hold the presidency and iShares iBoxx Investment Grade Corporate Bond (LQD) when Republicans hold it.
  3. D-IWM:R-IEF: hold IWM when Democrats hold the presidency and iShares 7-10 Year Treasury Bond (IEF) when Republicans hold it.

We use calendar years to determine party holding the presidency. As benchmarks, we consider buying and holding each of SPY, IWM, LQD or IEF and annually rebalanced portfolios of 60% SPY and 40% LQD (60 SPY-40 LQD) or 60% SPY and 40% IEF (60 SPY-40 IEF). We consider as performance metrics: average annual excess return (relative to the yield on 1-year U.S. Treasury notes at the beginning of each year); standard deviation of annual excess returns; annual Sharpe ratio; compound annual growth rate (CAGR); and, maximum annual drawdown (annual MaxDD). We assume portfolio switching/rebalancing frictions are negligible. Except for CAGR, computations are for full calendar years only. Using monthly dividend-adjusted closing prices for the specified ETFs during July 2002 (limited by LQD and IEF) through December 2022, we find that:

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Equity Factor Performance Before and After the End of 2000

Do the widely used U.S. stock return factors exhibit long-term trend changes and shorter-term cyclic behaviors? In his November 2022 paper entitled “Trends and Cycles of Style Factors in the 20th and 21st Centuries”, Andrew Ang applies various methods to compare trends and cycles for equity value, size, quality, momentum and low volatility factors, with focus on a breakpoint at the end of 2000. He measures size using market capitalization, value using book-to-market ratio, quality using operating profitability, momentum using return from 12 months ago to one month ago and low volatility using idiosyncratic volatility relative to the Fama-French 3-factor (market, size, book-to-market) model of stock returns. He each month for each factor sorts stocks into tenths, or deciles, and computes gross monthly factor return from a portfolio that is long (short) the average return of the two deciles with the highest (lowest) expected returns. As a benchmark, he uses the value-weighted market return in excess of the U.S. Treasury bill yield. Using market and factor return data from the Kenneth French data library during July 1963 through August 2022, he finds that:

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Why EW Beats VW

Why do equal-weighted (EW) portfolios outperform their market capitalization-weighted, or value-weighted (VW), counterparts over multiple decades in various investment universes? In their November 2022 paper entitled “Why Do Equally Weighted Portfolios Beat Value-Weighted Ones?”, Alexander Swade, Sandra Nolte, Mark Shackleton and Harald Lohre analyze drivers of differences in performance between EW and VW U.S. stock portfolios over six decades. They also assess consistency of performance drivers. Using monthly returns for a very broad sample of U.S. common stocks and monthly stock factor returns during July 1963 through December 2021, they find that:

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Turn of the Year and Size in U.S. Equities

Is there a reliable and material market capitalization (size) effect among U.S. stocks around the turn-of-the-year (TOTY)? To check, we track cumulative returns from 20 trading days before through 20 trading days after the end of the calendar year for the Russell 2000 Index, the S&P 500 Index and the Dow Jones Industrial Average (DJIA) since the inception of the Russell 2000 Index. We also look at full-month December and January returns for these indexes. Using daily and monthly levels of all three indexes during December 1987 through January 2022 (35 December and 35 January observations), we find that: Keep Reading

Are Equity Multifactor ETFs Working?

Are equity multifactor strategies, as implemented by exchange-traded funds (ETF), attractive? To investigate, we consider seven ETFs, all currently available:

We focus on monthly return statistics, along with compound annual growth rates (CAGR) and maximum drawdowns (MaxDD). Using monthly returns for the seven equity multifactor ETFs and benchmarks as available through August 2022, we find that: Keep Reading

O’Shaughnessy Micro Cap Strategy?

A subscriber, referring to a March 2016 commentary stating that “microcap stocks offer investors one of the best opportunities for consistent, long-term excess returns,” inquired about the performance of quality-value-momentum microcap strategy described therein. To assessment this strategy, we compare the self-reported annual performance of the O’Shaughnessy Micro Cap strategy (OSMC) as of June 2022 (now maintained by Franklin Templeton) to that of simply buying and holding SPDR S&P 500 ETF Trust (SPY). Using annual self-reported OSMC net returns and matched dividend-adjusted SPY returns during August 2007 through June 2022, we find that: Keep Reading

Do Equal Weight ETFs Beat Cap Weight Counterparts?

“Stock Size and Excess Stock Portfolio Growth” finds that an equal-weighted portfolio of the (each day) 1,000 largest U.S. stocks beats its market capitalization-weighted counterpart by about 2% per year. However, the underlying research does not account for portfolio rebalancing costs and may not be representative of other stock universes. Do exchange-traded funds (ETF) that implement equal weight for various U.S. stock indexes confirm findings? To investigate, we consider eight equal-weight ETFs, six alive and two dead:

We focus on average return, standard deviation of returns, reward/risk (average return divided by standard deviation of returns), compound annual growth rate (CAGR) and maximum drawdown (MaxDD), all based on monthly data. Using monthly dividend-adjusted prices for the 16 ETFs as available (limited by equal-weighted funds) through June 2022, we find that: Keep Reading

Failure of Equity Multifactor Funds?

Multifactor funds offer rules-based, diversified exposures to firm/stock factors found to beat the market in academic studies. Do the funds beat the market in real life? In his June 2022 paper entitled “Multifactor Funds: An Early (Bearish) Assessment”, Javier Estrada assesses performance of such funds across U.S., global and emerging markets relative to that of corresponding broad capitalization-weighted indexes and associated exchange-traded funds (ETF). He focuses on multifactor funds with exposure to at least three factors that are explicitly marketed as multifactor funds. Using monthly total returns for 56 U.S.-based equity multifactor funds with at least three years of data and $10 million in assets from respective inceptions (earliest June 2014) through March 2022, and total returns for matched broad market indexes and ETFs, he finds that:

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Interaction of Long-only Value and Size

Does the finding from long-short factor analysis that the value premium is stronger among small stocks than large stocks hold for long-only value portfolios? In his April 2022 paper entitled “Long-Only Value Investing: Does Size Matter?”, Jack Vogel investigates interactions between the value premium and market capitalization for U.S. and international stocks. The steps in his main analysis are to each year on June 30:

  • Group the 3,000 largest U.S. stocks by market capitalization with non-zero market value of equity into the 1,000 largest firms (large-cap) and the 2,000 smallest (small-cap).
  • Rank each group into thirds (terciles), fifths (quintiles) or tenths (deciles) based on each of: (1) book-to-market ratio (B/M); (2) earnings-to-price ratio (E/P); (3) free cash flow-to-price ratio (FCF/P); (4) earnings before interest and taxes-to-total enterprise value ratio (EBIT/TEV); and, (5) the composite rank of these four ratios.
  • Measure average monthly returns over the next year of the top ranks based on either equal weights (EW) or value weights (VW).

Using the specified accounting data and stock prices for a broad sample of U.S. firms since July 1973 and for a comparable sample of international developed market firms since January 1994, all through December 2020, he finds that: Keep Reading

Alternative Proxy for Small Stocks in Measuring the Size Effect

In response to “Measuring the Size Effect with Capitalization-based ETFs” and in view of the research summarized in “Quality-enhanced Size Effect”, a subscriber suggested using either iShares Core S&P Small-Cap ETF (IJR) or Vanguard S&P Small-Cap 600 Index Fund (VIOO) in place of iShares Russell 2000 ETF (IWM) as a proxy for small stocks. The idea behind this substitution is that IJR and VIOO select profitable companies from the S&P 600, while many Russell 2000 stocks are unprofitable. We choose IJR based on its much longer history, the same length as that for IWM. We again use SPDR S&P 500 ETF Trust (SPY) as a proxy for large stocks. We restate results for IWM for comparison. Using monthly dividend-adjusted closing prices for IWM, IJR and SPY during May 2000 (limited by IWM and IJR) through March 2022, we find that: Keep Reading

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