May 22, 2018

A Closer Look at the Size Factor

The size factor’s risk premium is among the most well-documented, and investing in small-cap companies has yielded consistent results over recent years. Somewhat surprisingly, the factor fared better than the benchmark even during the trying times of February and March this year, a period marked by heightened investor anxiety and increased volatility.

Size continues to outperform

This is an unusual development as small caps tend to do worse than the market in times of uncertainty, when investors seek safety in ostensibly more established companies, as smaller companies are often perceived to be more cyclical than their larger peers.

Since 2005, small caps as represented by the iSTOXX® Europe Size Factor Index have underperformed the STOXX® Europe Total Market Index in only three calendar years, all of which were times of economic downturn. In 2007, as the global financial crisis emerged, the Size index initially underperformed the broader market heavily: between April 2007 and December 2007, it slid 12.2% while the Total Market Index fell 1.5%.1 The broader market eventually caught up with the Size index’s losses in following months.

Smaller stocks also fared worse in 2011 amid the European debt crisis (–18.3% vs. –8.9%) and in 2014, a period of slow growth and threatening deflation (+3.5% vs. +7.1%).

So far, this pattern has not continued in 2018. While February and March saw the STOXX® Europe 600 Index drop 5.7%, the iSTOXX Europe Size Factor Index lost ground by only 4.2%. The iSTOXX® Europe Size Factor Market Neutral Index, which neutralizes systematic risk by holding a short position in futures on the STOXX Europe 600, returned 1.4%.

As markets recovered in April and May, the size factor’s outperformance has grown. The iSTOXX Europe Size Factor Index rose 8% between Apr. 1 and May 15, while the STOXX Europe 600 Index added 7.3%.

The theory behind the size premium

What is the size factor, anyway? The relationship between a stock’s total market value and its return was first unveiled by Rolf Banz in 1981. Banz found that smaller firms have higher risk-adjusted returns, on average, than larger firms.2 Since then the phenomenon has been studied extensively and replicated by numerous empirical studies across global markets.3

One reason behind that trend may be that small-caps sit at the best part of a company’s growth history. Smaller companies are better positioned to acquire market share from their competitors. Their less diversified businesses allow for more efficient capital allocation to growth opportunities, and their leaner set-ups help them respond to changing market dynamics more quickly.4

The size premium may also be a reward for investors taking on additional risk. Risk-based explanations for the size premium, on the one hand, include fundamental factors, as smaller companies are likely to be less established and less diversified,5 thus carrying higher financial risk.6 On the other hand, they may refer to transactional reasons, as small caps tend to be less liquid and more expensive to trade.7

On a behavioral basis, one could posit that smaller stocks may be overlooked due to a lack of investor recognition, insufficient research being available, or a general bias for larger firms.

Investing in factor premia

Due to its track record, size is one of six sources of systematic risk and returns in the iSTOXX® Factor Indices. The index family also includes value, momentum, carry, low risk and quality, and is completed by the iSTOXX® Europe Multi-Factor Index, which offers balanced exposure to all factors.

The iSTOXX Europe Size Factor seeks to extract that risk premium while mitigating some of the drawbacks inherent in small-cap investing – as well as other unintended risks. The index ranks stocks based on inverse market capitalization and inverse enterprise value. At the same time, it imposes rules – common to all iSTOXX Factor Indices – to help manage illiquidity and high transaction costs, while preserving exposure to the factor. It also tethers industry weights to the benchmark to avoid active sector bets.

Keeping an eye on quality and sustainability

Its current outperformance notwithstanding, there are downsides to the size factor, such as a negative relationship to the quality factor (solidity of finances) and low environmental, social and governance (ESG) scores, a recent article by IP&E reported.8

Small-cap companies do not tend to perform well in the ESG area. Although they may be managed sustainably, few are able to afford many programs needed to achieve high ESG scores. ESG-conscious portfolios will therefore tend to skew toward large caps.

Investors may consider combining strategies to avoid drawbacks, such as opting to invest in both quality and size portfolios, or combining a size approach with an ESG tilt.

Combining strategies

As the size factor keeps proving its worth, a factor index may be a good way to tap into the trend – especially when deployed as part of a comprehensive strategy and risks such as illiquidity and transaction costs are kept in check.

Featured Indices


1 Net-of-taxes total returns in euros
2 Banz, Rolf W., ‘The relationship between return and market value of common stocks,’ Journal of Financial Economics, 6, 103–126, March 1981.
3 Dimson, E., Marsh, P., and Staunton, M., ‘Factor-Based Investing: The Long-Term Evidence,’ The Journal of Portfolio Management, March 2017, 43 (5), 15-37.
4 Smith, S., ‘Small-cap ETFs offer access to superior growth and risk-adjusted returns’, Jul. 2, 2012.
5 Mariathasan, J., ‘Factor investing – is it overcrowded?’ I&PE, April 2018.
6 Van Dijk, M., ‘Is size dead? A review of the size effect in equity returns,’ Journal of Banking & Finance, May 2011, 35, 3263–3274.
7 Fama, E. F. and French, K. R., ‘Common risk factors in the returns on stocks and bonds,’ Journal of Financial Economics, February 1993, 33, 3–56.
8 Mariathasan, J., ‘Small caps: The smaller company effect‘ I&PE, April 2018.