Abstract

The finance literature has established a size effect: stocks with small market capitalization outperform larger stocks over the long term. The size factor is included in asset-pricing models because of its explanatory power for cross-sectional differences in equity returns. However, recent studies recommend removing size from the factor menu, given its relatively weak performance. Instead of looking at the stand-alone performance, we account for cross-factor correlation to assess the impact of excluding the size factor. We consider three tests. First, we measure the impact on model fit of asset-pricing models. Second, we assess whether the size premium remains intact when accounting for implicit exposures to other factors. Third, we evaluate the impact of the size factor on the performance of optimal multifactor portfolios. Our results suggest that the size factor improves model fit, delivers a significant positive premium in the presence of other factors, and contributes positively to the performance of multifactor portfolios. Omitting the size factor has substantial cost to investors, which often exceeds that of omitting other popular factors.

Scientific Portfolio AI- Generated Summary

This paper explores the question of whether the Size Factor still has its place in Multifactor Portfolios. The authors analyze the impact of excluding the Size Factor on model fit, the size premium, and the performance of optimal multifactor portfolios. They find that the Size Factor improves model fit, delivers a significant positive premium in the presence of other factors, and contributes positively to the performance of multifactor portfolios. Omitting the Size Factor has substantial costs to investors, which often exceed those of omitting other popular factors.

The authors review recent studies that are skeptical about the Size Factor and indicate poor performance relative to that of other factors. However, they argue that these studies fail to account for cross-factor correlation and the implicit exposure to other factors. They also note that small-cap investing is widespread in the asset management industry, and that the Size Factor carries a significant premium after adjusting for implicit exposure to other factors.

The authors conclude that the Size Factor should not be dropped from the menu in multifactor investments. They recommend that investors allocate to the Size Factor even if the return assumption is extremely conservative, as it improves diversification due to its low correlation with other factors and different exposure to macroeconomic conditions. They also suggest that a factor definition based on volume rather than market cap may be more appropriate.

Overall, this paper provides a compelling argument for the continued inclusion of the Size Factor in Multifactor Portfolios. The authors’ analysis highlights the importance of accounting for cross-factor correlation and implicit exposure to other factors when evaluating the performance of individual factors. Their findings suggest that the Size Factor remains a valuable component of multifactor portfolios, and that investors should carefully consider the costs of omitting it.