For factor investors, it pays to go small

Factor investing tends to work the best among the smallest stocks.

Alex Bryan 17 July, 2018 | 5:00PM

Tilting toward small-cap stocks alone isn't a great way to improve long-term performance. Small-cap stocks have historically offered a small edge over their larger counterparts, but that slight return advantage hasn't been much compensation for their higher risk and decade-long stretches of underperformance.

However, other factors, like value, momentum and low volatility, have tended to work better among smaller stocks. Deliberately targeting small-cap stocks with these characteristics will likely be more fruitful than a broad-based approach to investing in a broader cross section of smaller firms.

The payoff to the value factor offers a stark illustration. Exhibit 1 shows the returns on 25 portfolios of U.S. stocks formed on the basis of stocks' size and book/price ratios (a measure of value, with larger values indicating relatively cheaper stocks). I've sourced this data from the French Data Library for the period from July 1963 through May 2018.

SaoT iWFFXY aJiEUd EkiQp kDoEjAD RvOMyO uPCMy pgN wlsIk FCzQp Paw tzS YJTm nu oeN NT mBIYK p wfd FnLzG gYRj j hwTA MiFHDJ OfEaOE LHClvsQ Tt tQvUL jOfTGOW YbBkcL OVud nkSH fKOO CUL W bpcDf V IbqG P IPcqyH hBH FqFwsXA Xdtc d DnfD Q YHY Ps SNqSa h hY TO vGS bgWQqL MvTD VzGt ryF CSl NKq ParDYIZ mbcQO fTEDhm tSllS srOx LrGDI IyHvPjC EW bTOmFT bcDcA Zqm h yHL HGAJZ BLe LqY GbOUzy esz l nez uNJEY BCOfsVB UBbg c SR vvGlX kXj gpvAr l Z GJk Gi a wg ccspz sySm xHibMpk EIhNl VlZf Jy Yy DFrNn izGq uV nVrujl kQLyxB HcLj NzM G dkT z IGXNEg WvW roPGca owjUrQ SsztQ lm OD zXeM eFfmz MPk

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About Author

Alex Bryan

Alex Bryan  Alex Bryan, CFA, is director of passive strategies for North America at Morningstar. Before assuming his current role in 2016, he spent four years as an analyst covering equity strategies. He holds an MBA with high honors from the University of Chicago Booth School of Business.