Smaller stocks do not bring about bigger returns.
Yes, you read that correctly.
If there is a financial equivalent to what goes under the jargon “political correctness,” the good folks at Research Affiliates, specifically Vitali Kalesnik and Noah Beck, have just committed it in a new report called “Busting the Myth About Size.”
As the current fashion in today’s infantilized academic environment is to include so-called “trigger warnings” before saying something to which the audience might take offense, readers reaching for the smelling salts can revive themselves with the authors’ front-of-the-article assurance that small stocks might still be desirable investments.
But just as a Ptolemaic conception of the universe gave way to a Copernican one, which in turn yielded to a relativistic, Einsteinian one, the Research Affiilates duo have come to announce that the evidence supporting a return advantage for small stocks is largely spurious, despite its cherished status as an axiom of investment.
Kalesnik, head of equity research, and Beck, a researcher at the firm, based in Newport Beach, California, early on state that small stocks may add diversification value, and further that they are more subject to mispricing, and thus serve as “an alpha pool” for active managers and rules-based systems.
The purpose of this de facto trigger warning doubtless stems from the knowledge that the small-cap premium is entrenched in academic and professional finance. Indeed, it is one of the big three sources of return advantage in the original 1993 statement of the Fama-French three-factor model.
But taking a fresh look at the data, Kalesnik and Beck expose some anomalies therein that appear to shatter the “myth” of the small-cap premium.
One such anomaly derives from reduced impact of the small-cap effect in international data sets versus its seemingly robust impact in the U.S. But even in the U.S., there are problems.
So in a data set extending from July 1926 to July 2014, the small-cap premium is a whopping 3.4%, which is statistically significant.
But an international data set consisting of 18 countries including the United States from January 1982 through July 2014 shows a mere 1% return advantage on average. In some of those countries, small stocks underperformed. Though the average effect of small-caps was positive, and in the U.S. during that period added 1.9% to equity returns, in no place was the advantage of small-cap stocks statistically significant.
That finding impelled Kalesnik and Beck to look still closer at the long-term U.S. data set, which is the source of the idea that small-cap stocks confer a return premium, and there they discovered a number of serious problems.
The first and most important problem is that the data is not clean. By not accounting for small-cap stocks that were eventually delisted, the database essentially overestimates small-cap returns by omitting from the record companies whose delisting likely emanated from poor corporate performance.
The notion that delisted stocks tend to have strongly negative returns is not just intuitive. The Research Affiliates duo review data on small stocks listed on the Nasdaq and find that “after adjusting for the delisting bias, the statistical significance of the size premium completely disappears.”