Institutional Investors

In Defense Of The Size Premium

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This article originally appeared on ETF.COM here.

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Institutional Investors

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As director of research for Buckingham Strategic Wealth and The BAM Alliance, I’m often asked after any asset class or factor experiences a period of poor performance if the historical outperformance of stocks with that characteristic has disappeared because the premium has become well-known and arbitraged away.

In May, I addressed the issue of the “disappearing” value premium. Today I will look at the size premium. (Note: I also addressed the size premium in a June article.)

The size premium's relatively poor performance in U.S. stocks over the seven-year period from 2011 through 2017 caused many investors to question its persistence. Using Fama-French data, the annual premium was negative in five of the seven years, with returns of -6.0%, -1.2%, +7.3%, -8.0%, -3.9%, +6.6% and -4.8%, respectively. The annualized premium over that period was negative 1.4%.

When asked to address this type question, the first thing I generally point out is that all factors, including market beta, have gone through – and likely will continue to go through – very long periods of negative premiums. That must be the case, or there would be no risk when investing in them, and efficient markets would arbitrage away any premium.

Supporting evidence

The following table shows the odds of a negative premium, expressed as a percentage of the three Fama-French factors of market beta, size and value. Data is from the Fama/French Data Library, and the period is 1927 through 2017.

As you can see, at even 20 years, the equity premium was negative in 3% of periods. For the size premium, the most recent seven-year period certainly isn’t unusual, as it was negative in almost one-quarter of even 10-year periods.

Size Premium

The lesson here is that if you are considering investing in any factor, you should be prepared to endure long periods of negative premiums and understand the importance of staying disciplined.

One reason investors fail to earn market returns is that they lose discipline, which is why Warren Buffett – recognizing that once you have ordinary intelligence, temperament is more important than intellect when it comes to investing – has stated that investing is simple, but not easy.

There’s another point worth noting, and it demonstrates the importance of diversification. While the U.S. size premium was a negative 1.4% during the aforementioned seven-year period ending in 2017, the international size premium was actually positive at 1.8%.

Again, using Fama-French data, the international size premium was 7.8% in 2015, 5.7% in 2016 and 4.8% in 2017. If the size premium in the U.S. had disappeared because it was well-known, one might think it would also have disappeared in the rest of the developed world.

Read the full article here by Larry Swedroe, Advisor Perspectives

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