Moving Down the Market-Cap Ladder Amplifies Factor Exposures (Part 2)

Examining momentum and low profitability

Alex Bryan 21 September, 2017 | 15:01
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In part 1 of this article, we examined how value and low volatility factors have worked among smaller-cap stocks. In part 2, we will examine the momentum and profitability factors.

Momentum
Momentum has also tended to offer the best returns among the smallest stocks, at least on paper, as Exhibit 4 shows. In practice, the transaction costs of this high-turnover strategy would eat a big chunk of these hypothetical returns, so a micro-cap momentum strategy isn’t advisable. But this return pattern provides further support for the idea that there is greater mispricing among the smallest stocks in the market than there is among large caps.

170921 marketcapsb 04(en)

Momentum likely arises because investors are slow to react to new information, causing prices to adjust more slowly than they should. Because smaller stocks don’t attract as much attention as larger ones, it probably takes longer for new information to be reflected in their prices, which could explain why the returns to momentum are higher among smaller names. Once a trend is established, investors may pile into the trade, pushing prices away from fair value, leading to the long-term reversals associated with the value effect. So, this bigger momentum effect among small stocks is also consistent with a bigger value effect.

Profitability
Unlike the other factors, profitability (investing in the most-profitable firms) worked almost as well among large-cap stocks as it did among the smallest stocks, as illustrated in Exhibit 5. It isn’t obvious why this factor bucked the small-cap amplification pattern. However, it may have something to do with the fact that the largest stocks in the market tend to be the most profitable.

170921 marketcapsb 05(en)

Highly profitable stocks tend to be less volatile and hold up better during market downturns than their less-profitable counterparts. So, if anything, it would be reasonable to expect these stocks to offer lower returns for their relative safety. Of course, there is always a risk that they could underperform, as they often do during strong market rallies.

It is likely that mispricing across the market-cap spectrum contributed to this effect. For example, highly profitable stocks could become undervalued if investors do not fully appreciate the long-term sustainability of their earnings power. Or they may simply prefer riskier stocks that offer greater return potential, similar to the low-volatility effect. Yet, to the extent that the profitability and low-volatility effect arise from a common bias, it is a bit of a puzzle why the former wasn’t also much bigger among the smallest stocks. 

The U.S. results were consistent with the factor return patterns among international stocks. I ran a similar analysis using the global ex-U.S. portfolios formed on profitability, value, and momentum (low-volatility portfolios weren’t available) from November 1990 through May 2017. Value and momentum worked much better among the smallest stocks than among the largest, while profitability only worked slightly better among the smallest stocks.

Small-Cap Factor Amplification
Although each of the factors examined here, apart from profitability, performed much better among small-cap stocks than among large ones, the vast majority of assets invested in factor strategies are in large-cap funds. It's true that large-cap strategies have greater capacity than their small-cap brethren and are less risky, generally making them better core holdings. And yes, transaction costs will likely create a bigger drag on a momentum strategy applied to small caps than to large caps. But the performance advantage from tilting toward factors like value and low volatility is nonetheless likely to be larger among small-cap stocks.

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Alex Bryan

Alex Bryan  Alex Bryan, CFA is the Director of Passive Fund Research with Morningstar.

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