Size Effect

If noise is a significant component of stock prices, does a portfolio that favors large market capitalization stocks automatically underperform? In the May 2006 draft of their paper entitled “Pricing Noise, Rejecting the CAPM and the Size and Value Effects”, Robert Arnott and Jason Hsu examine the implications of a very simple model that assumes stock prices deviate from fundamental value based on a single source of unknown risk (noise). They assume the deviations revert to a mean of zero, with no long-term effect on stock returns. Based on this model, they conclude that: Keep Reading

As companies evolve, their characteristics may migrate from one category to another (for example, from small to large, or from growth to value). Does such migration, in aggregate, help explain differences in average returns for different categories of stocks? In the August 2006 draft of their paper entitled “Migration”, Eugene Fama and Kenneth French investigate how migration of firms across categories contributes to the size effect and the value premium. Specifically, at the end of each June from 1926 through 2004 they construct six value-weighted portfolios of stocks from the major U.S. exchanges based on market capitalization and price-to-book ratio. They then examine the effects on portfolio returns of four kinds of annual rebalancing actions: (1) firms that do not move (Same); (2) firms that change size (dSize); (3) firms that improve toward growth, or are acquired (Plus); and, (4) firms that deteriorate toward value, or are delisted (Minus). Using subsequent-year return data for 1927-2005, they conclude that: Keep Reading

Can you trade on the CBOE Volatility Index (VIX), the “investor fear gauge,” or not? If so, what should you trade and should your trades be short-term or long-term? In their September 2005 paper entitled “VIX Signaled Switching for Style-Differential and Size-Differential Short-term Stock Investing”, Dean Leistikow and Susana Yu test the usefulness of VIX level as a signal for short-term switching between: (1) value and growth stock indexes; and, (2) small-capitalization and large-capitalization stock indexes. They note that “…VIX can be viewed as a market-determined forecast of short-term market volatility that, by construction, has a constant one-month forecast horizon.” They determine signals according to whether VIX is high or low compared to its 75-day moving average. They examine index returns for 1 day and 5 days after a VIX signal. Using data for the VIX and for various Standard & Poor’s and Russell stock indexes from the early 1990s through 2004, they find that: Keep Reading

We have selected for retrospective review a few all-time “best selling” research papers of the past few years from the General Financial Markets category of the Social Science Research Network (SSRN). Here we summarize the August 2003 paper entitled “Bad Beta, Good Beta” (download count over 1,700) by John Campbell and Tuomo Vuolteenaho. In this research, the authors separate stock beta into two components, one reflecting news about cash flows and one reflecting news about discount rates. They apply this decomposition to explain the size effect and the value premium. They hypothesize that:

[Market] “value…may fall because investors receive bad news about future cash flows; but it may also fall because investors increase the discount rate…that they apply to these cash flows. In the first case, wealth decreases and investment opportunities are unchanged, while in the second case, wealth decreases but future investment opportunities improve. …[A]n investor may demand a higher premium to hold assets that covary with the market’s cash-flow news than to hold assets that covary with news about the market’s discount rates, for poor returns driven by increases in discount rates are partially compensated by improved prospects for future returns. …The required return on a stock is determined not by its overall beta with the market, but by its bad cash-flow beta and its good discount-rate beta. Of course, the good beta is good not in absolute terms, but in relation to the other type of beta.” [Underlining is ours.]

Using monthly returns from an early period (January 1929 through June 1963) and a modern period (July 1963 through December 2001) to test this idea, the authors conclude that: Keep Reading

Which cheap (high book-to-market value) stocks drive the value premium? Can investors capture the value premium by simply buying a broad index of value stocks, or should they focus on some easily identifiable subset. The paper “Institutional Ownership and the Value Premium” by Ludovic Phalippou from April 2005 evaluates level of institutional ownership as the driver of the value premium, hypothesizing that mispricing of stocks is mostly like to come from unsophisticated individual investors. Using data for 1980-2001, he concludes that: Keep Reading

As worldwide economic participation broadens and deepens, are large companies (more than small companies) becoming internationally owned and therefore priced? In other words, are large companies subject to a worldwide equity risk premium while small companies remain moored to local risk premiums? In his paper entitled “Financial Integration and the Price of World Covariance Risk: Large vs. Small-cap Stocks” (forthcoming in the Journal of International Money and Finance), Wei Huang investigates whether global pricing is peculiar to large-capitalization stocks. Using three size-based stock portfolios for nine developed countries (Australia, Netherlands, Canada, France, Germany, Italy, Japan, U.K. and U.S.) over the period 1980-2004, he concludes that: Keep Reading

Do long-term investors in small-capitalization firms outperform? Is the size effect simply a manifestation of data snooping or defective statistical methodologies? In his January 2006 paper entitled “Is Size Dead? A Review of the Size Effect in Equity Returns”, Mathijs van Dijk reviews the international evidence for the size effect and synthesizes the debate on its theoretical validity and empirical persistence. He concludes that: Keep Reading

Do long-term value investors outperform? In their paper entitled “Do Investors Capture the Value Premium?”, Todd Houge and Tim Loughran seek the answer to this question by examining groups of value and growth equity indexes, mutual funds and individual stocks over long periods. They conclude that: Keep Reading

In their December 2005 paper entitled “Information and Prospects: Investment Opportunities and Market Efficiency in the Small-Cap Segment”, German Espinosa and Robert Veszteg examine the value of analysts as guides for selecting stocks that amplify the small firm effect. Is it better to search independently for “hidden gems” or to focus instead on small stocks followed by analysts? Are those analysts one step ahead in the relatively slow diffusion process for new information about small firms? The authors test the hypothesis that small firms with unusually large analyst followings tend to be those with the best prospects. Using monthly data on financial analyst coverage and returns for the stocks of U.S. and Canadian markets between June 1996 and June 2004, they find that: Keep Reading

In their October 2005 paper entitled “The January Effect”, Mark Haug and Mark Hirschey examine the persistence of the January effect (abnormally high rates of return during the month of January). Using broad samples of value-weighted and equally-weighted returns spanning 1802-2004 for large-capitalization stocks and 1927-2004 for small-capitalization stocks, they conclude that: Keep Reading