Is size dead? A review of the size effect in equity returns
Introduction
In this paper, I examine the evidence on the validity and persistence of the size effect in the cross-section of equity returns and the debate about the explanations for the effect. I also assess the implications for academic research and corporate finance. My review starts with a survey of the empirical studies up to and including Fama and French (1992). Subsequent studies focus on explaining the size effect. Since the late 1990s, a remarkable paradox has developed in research on the size effect. The objections against the lack of theory behind risk-based explanations for the size effect have at last resulted in the development of several theoretical models in which the size effect arises endogenously as a result of systematic risk. On the other hand, empirical research suggests that the size effect has disappeared since the early 1980s. This paradox has brought a virtual halt to research on the size effect.
I argue that there are two reasons why we need further empirical and theoretical research on the size effect. First, because it is premature to conclude that the size effect has gone away. Stock returns are very noisy and standard errors around estimates of the size premium are large, so it is not easy to tell whether the size effect is larger or smaller than it used to be. (In fact, I show that the US size premium was substantial in recent years.) The international evidence is also inconclusive. Second, because although the theoretical explanations offered for the size effect are potentially valuable, whether and how existing models can be reconciled with known patterns in the returns on small and large stocks is not clear. In particular, we need more empirical and theoretical research to evaluate the extent to which theories based on firm-level investment decisions, stock market liquidity, and investor behavior can explain the size effect.
The paper is structured as follows. I present an overview of the empirical evidence on the size effect in US and international stock markets in Section 2. In Section 3, I discuss a number of objections to the methods used in the empirical literature. In Section 4, I examine alternative explanations for the size effect. I assess the current state of the empirical and theoretical literature and discuss implications and directions for further research in Section 5. Section 6 concludes.
Section snippets
Empirical evidence on the size effect
In this section, I survey empirical studies on the size premium in US stock returns up to and including Fama and French (1992). I also present an overview of the international evidence on the size effect.
Critique on the methods of empirical studies
In this section, I assess the most prominent criticisms of various studies’ methods and their bearing on the reliability of the empirical evidence on the size effect.
Explanations for the size effect
The question why small firms earn higher returns than traditional asset pricing models predict has become the subject of a heated debate. Some papers contend that the systematic risk of a stock is driven by multiple risk factors, and firm size is a proxy for the exposure to state variables that describe time-variation in the investment opportunity set. An alternative interpretation is that the size premium is a compensation for trading costs and/or liquidity risk. A third fundamental
Implications for academic research and corporate finance
In this section, I evaluate the current state of empirical and theoretical research on the size effect.
Many of the early empirical studies identify a significant and consistent size premium in US equity returns, but more recent papers report that the effect may not be robust over time. It is remarkable that hardly any research has addressed the question of whether structural or institutional changes can account for the decrease in the size premium since the early 1980s – and for its strong
Conclusion
Banz (1981) concludes his study on the size effect in US stock returns as follows: “It is not known whether size per se is responsible for the effect or whether size is just a proxy for one or more true unknown factors correlated with size” (his emphasis). Since the publication of Banz’s 1981 paper, a huge body of literature has developed on the size effect. The size effect has been investigated empirically for many countries, and numerous studies have attempted to explain the anomaly. Academic
Acknowledgements
I thank Ike Mathur (the editor), an anonymous referee, Jonathan Berk, Long Chen, Karl Diether, Rüdiger Fahlenbrach, Ken French, David Hirshleifer, Kewei Hou, Kees Koedijk, Geert Rouwenhorst, Pieter van Oijen, and Christian Wulff for helpful suggestions and discussion. I am grateful for the hospitality of the Department of Finance at the Fisher College of Business (Ohio State University) where some of the work on this paper was performed. I thank Sandra Sizer for editorial assistance and
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