Moving Down the Market-Cap Ladder Amplifies Factor Exposures (Part 1)

The column labeled “5–1” in Exhibit 1 shows the return spread between the portfolios of the cheapest and most-expensive stocks across five different size strata. So, for example, the cheapest fifth of U.S. large-cap stocks outpaced the most-expensive fifth by 1.93 percentage points annually, which isn’t bad. But the return gap between deep-value and high-growth stocks increases dramatically as we move down the market-cap ladder. 

To understand this performance pattern, it is important to understand the explanations for the value effect more broadly. Value stocks are thought to outperform either because they are riskier than their more-expensive counterparts and offer higher expected returns to compensate investors for that risk, or because they are mispriced. The risk-based explanation is plausible. Value stocks tend to have less-attractive business prospects than more richly valued stocks. That said, growth stocks—especially small-growth stocks— come with significant risks of their own, most notably the risk of failing to live up to the lofty expectations embedded in their prices.

During the sample period, the large-value portfolio did in fact exhibit greater volatility and a larger maximum drawdown than its growth counterpart. But the opposite was true of the small-value portfolios, as shown in Exhibit 2. This suggests that these value portfolios were less risky than their growth counterparts and that mispricing is the more likely driver of their higher returns. It's reasonable to believe that small-cap stocks are more prone to mispricing than large-cap stocks because they don’t attract as much investor attention or analyst coverage. Consequently, their prices may not reflect all publicly available information. However, we can’t rule out the risk-based explanation for the value effect among small-cap stocks because risk can still be present without being realized. For example, even if a corporate borrower doesn’t default on a loan, that outcome is still possible and investors must be compensated for that risk.

Low Volatility
As is the case with value, the advantage of tilting toward low-volatility stocks has historically been the biggest amongst the smallest stocks, as Exhibit 3 illustrates. This table shows the returns on 25 portfolios of U.S. stocks sorted on size and volatility for the previous 60 days, updated monthly. The return spread between the least- and most-volatile fifth of U.S. large-cap stocks was 1.65 percentage points annualized from July 1963 through June 2017, but the corresponding figure among micro-cap stocks was 19.87 percentage points annually.

The inverse relationship between stocks’ size and the efficacy of the low-volatility effect likely stems from greater mispricing among smaller stocks. For instance, there may be greater lottery-seeking behavior among small-cap stocks, where investors overpay for volatile stocks that offer a small chance for a big payoff, because these stocks tend to offer greater upside potential than their larger counterparts. But that’s not the whole story. A regression analysis revealed that the low-volatility portfolios tended to favor cheaper and more-profitable stocks than their more-volatile counterparts. So, one of the reasons the low-volatility effect works the best among the smallest stocks is because it partially captures the value effect. Additionally, the low-volatility portfolios had greater exposure to the momentum factor (which has historically been associated with higher returns), and this gap was the widest among micro-cap stocks and the narrowest among large-cap stocks. This suggests that momentum contributed to the greater efficacy of the low-volatility strategy among the smallest stocks.

In part 2 of this article, we will examine how momentum and profitability factors have worked among smaller-cap stocks.