Scientific Beta defends the role of the Size factor in multi-factor portfolios

Scientific Beta defends the role of the Size factor in multi-factor portfolios

Research shows that omitting the Size factor would be costly for investors

New research from Scientific Beta, the smart beta index provider, has shown 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 multi-factor portfolios.

The Size effect is well established in the finance literature: stocks with smaller market capitalisation outperform large stocks over the long term. However, a common recommendation in the asset management industry is to remove Size from the factor menu, given its relatively weak post-publication performance.

Scientific Beta's analysis differs from recent studies by smart beta providers in assessing the relevance of the Size factor. Rather than asking which factor has the best stand-alone performance, we ask what the marginal impact of the Size factor is when including it in the menu along with other factors. In Scientific Beta's research, three different tests of the Size factor are considered:

1. Impact on model fit of asset pricing models. Exclusion of the Size factor from a multi-factor asset-pricing model leads to a 22% increase in the proportion of unexplained returns of portfolios sorted by characteristics. This suggests that excluding Size seriously deteriorates model fit.

2. Assessment of whether the Size premium remains intact when accounting for implicit exposures to other factors. We find that the Size premium is economically and statistically significant over the long-term US history when accounting for the presence of other commonly used equity factors.

3. Evaluation of the Size factor’s impact on optimal multi-factor portfolio performance. Size offers diversification benefits due to its low correlation with other factors. Due to diversification effects, the Size factor would keep a role in the optimal multi-factor portfolio even if the Size premium were lower than what has been observed historically.

In short, omitting the Size factor has substantial cost to investors, which often exceeds that of omitting other popular factors.

The Scientific Beta white paper can be accessed through the link below:

Does the Size Factor Still Have Its Place in Multi-Factor Portfolios? Scientific Beta White Paper, July 2019

As part of its policy of transferring know-how to the industry, EDHEC-Risk Institute has set up Scientific Beta. Scientific Beta is an original initiative which aims to favour the adoption of the latest advances in smart beta design and implementation by the whole investment industry. Its academic origin provides the foundation for its strategy: offer, in the best economic conditions possible, the smart beta solutions that are most proven scientifically with full transparency of both the methods and the associated risks.
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