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A Survey of the Small-firm Effect

DISCUSSION NOTE 12 - 15 October 2012

The small-firm effect (SFE) refers to the long-term average excess returns that a portfolio of small-capitalisation stocks earns over a portfolio of large-capitalisation stocks. In this note, we review the extensive empirical evidence on the SFE and the various theoretical explanations that researchers have put forward for the effect.

Main findings

  • The outperformance of small-cap stocks over large-cap stocks is a well-documented observation in financial research. In the US, small-cap stocks outperformed large-cap stocks by three percent per annum over the period 1927-2011. Global small-cap stocks also tend to outperform global large-cap stocks over long time horizons. The positive relationship between firm size and stock returns is non-linear across firm size and is strongest for the smallest firms in the sample.
  • The SFE varies significantly over time. Historically, the SFE has gone through periods of continued out- and underperformance. Most notably, in the two decades after 1981, the year when the SFE was first documented, small firms underperformed large firms in both the US and the UK. More recent evidence points towards a reversal of this trend. Due to the high riskiness of the SFE, an investment strategy attempting to exploit the effect may only pay off over relatively long periods of time.
  • The SFE appears to vary with the stocks’ book-to-market ratio. The effect is strong and positive for the stocks with relatively high book-to-market (value) and weak and even negative for the stocks with low book-to-market (growth). Unlike the SFE for growth stocks, the SFE for value and neutral stocks has persisted after 1981. In absolute terms, small growth stocks have been among the worst performers in the past three decades.
  • The SFE in the US tends to concentrate in January. A popular explanation for this observed seasonality is the tax-selling hypothesis, the proposition that some investors sell securities at year-end to establish capital losses for income tax purposes, thereby putting downward pressure on security prices. Small-cap stocks, which are typically stocks that have recently diminished in market value, tend to be the first stocks to be sold. Alternative explanations include the windowdressing hypothesis, the proposition that institutional investors sell “loser” stocks at quarter-end to improve the appearance of their portfolios.
  • The outperformance of small-cap stocks cannot be attributed solely to market risk. The CAPM’s failure to explain the SFE and the related value effect has triggered an ongoing debate regarding the nature of these stock market regularities. Research suggests that the SFE may be (1) a proxy for a non-diversifiable risk factor such as cash flow risk, business cycle risk or liquidity risk; (2) a statistical artefact resulting from measurement errors, data mining and various methodological biases; and (3) a result of irrational investor biases.
  • Estimates of the SFE may be plagued by statistical inference biases arising from “data snooping” and from performing tests on pre-sorted portfolios. Some empirical evidence also suggests that the riskiness of small-cap stocks may be biased downward due to serial correlation in small-cap returns, while estimates of average small-cap returns may be biased upward due to a type of survivorship bias in commonly used data samples. Statistical issues, however, cannot fully explain the observed SFE in the data.
  • Proponents of behavioural finance suggest that the SFE may be explained by investor biases. The SFE may represent market correction to an investor reaction that creates “losers” (stocks with low recent returns, typically small-cap stocks) and “winners” (stocks with high recent returns, typically large-cap stocks). Another theory holds that investors tend to overvalue small-cap stocks compared to large-cap stocks when investors are particularly bullish and undervalue them when they are bearish.
  • Proponents of rational expectations favour risk-based explanations for the SFE. Firm size is viewed as a proxy for some non-diversifiable source of risk that drives the cross-section of expected returns. Some evidence suggests potential links between firm size and cash flow, bankruptcy and distress risk, as well as between size and various macroeconomic variables. Another theory holds that the lower liquidity of small-cap stocks is a source of risk leading to higher returns, and that temporal shifts toward greater liquidity in small-cap equity markets during the 1980s may account for the weak SFE between 1980 and 2000.

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