The Small-Cap Effect Lives -- With A Twist

Small stocks have lagged their larger peers over the past decade. But does that mean the “small-firm effect” is dead? Not exactly, says Mark Hulbert in a recent Barron’s column.

“The idea that small stocks outperform large stocks over the long term — the so-called ‘small-firm effect’ — used to enjoy an impressive academic seal of approval,” Hulbert says. “In fact, it was one of the first exceptions — or anomalies — that academics discovered to the Efficient Market Hypothesis.” But since publication of the 1981 University of Chicago study that first publicized the small-firm effect, small-cap stocks haven’t enjoyed an edge. “As a result, according to New York University finance professor Andrea Frazzini, a repeat of the 1981 study using all available historical data today would not conclude that there is a small-firm effect,” Hulbert writes.

But Frazzini, a principal at AQR Capital Management, and four others from AQR have published a study that “resurrects” the small-firm effect by adding another element to the mix: quality, which is measured by such variables as profitability, profit growth, low stock return risk and stability of earnings, and high payout and a conservative investment policy. “Among stocks of similar quality, those with the smallest market value historically have significantly outperformed the largest” according to the study, Hulbert says.

You can find the study, entitled “Size Matters, if You Control Your Junk,” here.