Financials Trading System & Strategy: Size Effect

Financials Trading Strategy Size Effect is also known as the small firm effect and is simply the tendency for small cap stocks to outperform large cap stocks over time

Here, smaller cap stocks are typically referred to as companies trading for less than $2 billion in market cap. The small firm effect is one of the three factors in the Three Factor Model by Eugene Fama and Kenneth French. (The two others are CAPM and value).

Financials Trading Strategy Size Effect Explanation

One explanation for the size effect is that small cap stocks are simply more risky than large cap stocks. They must therefore command a higher rate of return.

Another explanation is that small cap stocks have the ability to grow faster and harder than larger companies which can be constrained by their own level of success.

However, the size effect has been called into question by some researchers who say the anomaly is inconsistent, concentrated among microcaps, and strongest in the month of January.

The following graphic from Aswath Damodaran with data from Ken French calls the small firm effect into question and illustrates how most of the returns have come in January:

Financials Trading Strategy Size Effect

Trading System & Strategy:

There is evidence that the small firm effect has weakened. However, investors may still outperform by selecting small caps with higher quality earnings (as discussed in this paper by AQR).

Also, the small firm effect is clearly more prominent in January. You can buy baskets of small cap stocks and simultaneously short large cap stocks if looking for a market neutral approach.

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