Abstract

In the earliest days of empirical work in academic finance, the size effect was the first market anomaly to challenge the standard asset pricing model and prompt debates about market efficiency. The notion that small stocks have higher average returns than large stocks, even after risk adjustment, was a path-breaking discovery, and for decades it has been taken as an unwavering fact of financial markets. In practice, the discovery of the size effect fueled a crowd of small-cap indexes and active funds to the point that the investment landscape is now segmented into large and small stock universes. However, despite its long and illustrious history in academia and its commonplace acceptance in practice, there is still confusion and debate about the size effect. We examine many claims about the size effect and aim to clarify some of the misunderstanding surrounding it by performing simple tests using publicly available data. For one, using 90+ years of U.S. data, there is no evidence of a pure size effect; moreover, it may not have existed in the first place, if not for data errors and insufficient adjustments for risk and liquidity.

Scientific Portfolio AI- Generated Summary

The paper titled “Fact, Fiction, and the Size Effect” explores the size effect in finance, which refers to the tendency for small-cap stocks to outperform large-cap stocks over time. The authors provide a comprehensive review of the literature on the size effect, including its history, empirical evidence, and theoretical explanations.

The paper begins by tracing the origins of the size effect to the seminal work of Rolf Banz in the early 1980s, who first documented the phenomenon in the US stock market. The authors then review the subsequent literature on the size effect, which has produced mixed and sometimes conflicting results. While some studies have confirmed the existence of the size effect, others have found it to be weak or nonexistent, particularly in international markets.

The authors then turn to the theoretical explanations for the size effect, which include risk-based, behavioral, and liquidity-based models. They argue that while each of these models has some empirical support, none of them fully explains the size effect on its own. Instead, the authors suggest that a combination of these factors, along with other market frictions and anomalies, may be responsible for the persistence of the size effect over time.

The paper also explores the practical implications of the size effect for investors, including the use of size-based investment strategies and the potential risks and challenges associated with these strategies. The authors note that while size-based strategies can be profitable, they also require careful attention to transaction costs, liquidity, and other factors that can affect returns.

Finally, the authors discuss some of the debates and challenges surrounding the size effect, including the potential for data mining and sample selection biases, as well as the role of recent market trends and changes in the global economy. They conclude that while the size effect remains a controversial and complex topic in finance, it is an important area of research that can help investors better understand the dynamics of the stock market and develop more effective investment strategies.