Scientific Beta

Webinar replay - 24 November, 2020: "Is there still room for the Size factor in the factor menu?"

This article, published in the Winter 2019 issue of the Journal of Index Investing, focuses on the cost or benefit of removing the size factor from the menu of factors and also compares the results to the consequences of removing other factors. The finance literature has established a size effect: stocks with small market capitalization outperform larger stocks over the long term. The size factor is included in asset-pricing models because of its explanatory power for cross-sectional differences in equity returns. However, recent studies recommend removing size from the factor menu, given its relatively weak performance. Instead of looking at the stand-alone performance, we account for cross-factor correlation to assess the impact of excluding the size factor. 

The finance literature has established a size effect: stocks with small market capitalization outperform larger stocks over the long term. The size factor is included in asset-pricing models because of its explanatory power for cross-sectional differences in equity returns. However, recent studies recommend removing size from the factor menu, given its relatively weak performance. Instead of looking at the stand-alone performance, we account for cross-factor correlation to assess the impact of excluding the size factor. We consider three tests. First, we measure the impact on model fit of asset-pricing models. Second, we assess whether the size premium remains intact when accounting for implicit exposures to other factors. Third, we evaluate the impact of the size factor on the performance of optimal multifactor portfolios. Our results suggest that the size factor improves model fit, delivers a significant positive premium in the presence of other factors, and contributes positively to the performance of multifactor portfolios. Omitting the size factor has substantial cost to investors, which often exceeds that of omitting other popular factors.

More information: Webinar replay - 24 November, 2020: "Is there still room for the Size factor in the factor menu?"