The demand for small-cap equity strategies has been noticeably stronger among our pension fund clients through the ongoing late phase of the market cycle.
The underlying motivations for seeking small-cap equities have evolved: rather than counting on a "size premium," investors are seeking to improve the diversification of their existing equity exposures and, in certain markets, take advantage of strong active manager performance. In doing so they are also grappling with a changing manager landscape, particularly the recent proliferation of global small-cap funds.
Few risk premiums have as illustrious — and controversial — a history as size. One of the three factors used in the Fama/French three-factor model alongside "value" and "market," it has been the subject of more academic papers than any other member of the factor family. Many of these were produced in the 1980s, beginning with Rolf Banz's seminal article in 1981. In the face of data that appeared to suggest that a size premium did exist, theories were propounded for why it should exist. These included the pricing inefficiencies that can result from limited analyst coverage, lower liquidity and the supposedly easier growth trajectory.
Yet the size premium has now been extensively unpicked. At first glance, before adjusting for risk or for the various style premiums, small-cap indexes have outperformed large-/midcap indexes since 2000 on both a global and a regional basis. Yet the size effect is statistically insignificant once the data has been adjusted for beta, and even more so when other now-popular analytical methods are applied such as style regressions. What remains is undermined by the greater illiquidity and higher trading costs involved.
That said, our analysis suggests that a statistically significant size premium resurfaces once indexes are regressed against the quality factor. We find that the addition of the quality factor not only raises the average return to size significantly but also increases the precision of the size premium.