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The size factor refers to the empirically verified phenomenon that mid- and small-cap stocks – with a market capitalisation of between $2 billion and $10 billion, and less than $2 billion respectively – generally outperform large-cap stocks, which have a total capitalisation of $10 billion-plus.
The discovery of the size factor marked the beginning of the factor investing boom, as investors were able to tilt their portfolios to stocks with a smaller total capitalisation as a means to improve their risk-adjusted returns.
The best-known academic research on the size factor is the 1992 paper The cross-section of expected stock returns by Kenneth French and Eugene Fama, which posited that more than 90% of a stock’s returns can be attributed to the size of the company, the exposure to the overall market, and the price-to-book value ratio (the value factor). However, earlier research had already found that, over long time periods, smaller companies deliver a higher premium than larger ones.
While the source of the size premia is disputed, many believe is it related to the idea that investors receive compensation for taking the greater risk of buying shares that may be less liquid than large caps or, alternatively, more susceptible to changing business cycles, defaults and volatility. Small-cap stocks might also tend to outperform because it is easier for them to display outsized growth.
Unlike the momentum factor, the size factor has not consistently delivered excess returns over time, with some even positing that the premium has disappeared.