Size matters, right? For the past 35 years some of the most influential voices in finance have claimed that small stocks outperform large stocks. In fact, the so-called size effect has been credited as one of the main drivers of long-term stock market returns. But not everyone is convinced. Some complain that the effect disappears for long periods, or only really wins big in January. Others claim that profits from a small stock strategy get wiped out when you factor in trading costs. Could it be that big profits at the small end of the market simply don't exist?
Well, new research claims to have debunked all of these concerns. It turns out the size effect does exist. And it's very much a powerful force in the market - but only if you combine it with another key ingredient: quality.
Quality… minus junk
In late 2013, Cliff Asness and his team of quant researchers at US fund management firm AQR Capital, came up with a strategy called Quality Minus Junk. Their research found that safe, profitable, growing, and well managed companies don't get the credit they deserve - in the form of significantly higher share prices. So a QMJ strategy that buys high-quality stocks and shorts low-quality stocks earns significant risk-adjusted returns.
AQR's research came a time when 'quality' was rising through the ranks as a factor that investors were taking seriously. Last year, investment adviser Research Affiliates looked at the effectiveness of using quality and value factors together, in The Moneyball of Quality Investing. Even Eugene Fama and Ken French, who originally introduced the famous three-factor model, made improvements to it last year, with a five factor model that uses a quality component.
Small beats big
The latest development in this chain of events is that AQR has found that if you apply the QMJ strategy to small stocks, the size effect becomes much more pronounced. In their latest paper “Size Matters, If You Control Your Junk" they show that small quality stocks outperform large quality stocks.
What they found sounds intuitive. That is, small stocks generally tend to be more 'junky' than big stocks. They're small for a reason. They might be unprofitable, growth might be slow (or static), they're risky and they don't offer attractive returns to investors. With so many junky companies around, it turns out the size effect gets lost. But if…
