The Case for Small Cap and Value
DIMENSIONAL FUND ADVISORS
IN RECENT DECADES, RESEARCHERS HAVE DISCOVERED a number of interesting results by studying the world’s stock markets. Two of the more interesting discoveries are the size effect and the value effect. The size effect refers to the tendency for small cap stocks to have higher average returns than large cap stocks. Banz (1981) shows that this return difference persists after controlling for systematic (beta) risk, and Fama and French (1992) show that it persists after controlling for a number of other factors, including leverage. Companies with high ratios of earnings/price, cash ﬂow/price, and book equity/market equity are frequently referred to as value companies, and ﬁrms with low ratios are called growth companies. The value effect refers to the tendency for value stocks to have higher average returns than growth stocks. The value effect was originally documented in the US (Basu 1977; Rosenberg, Reid, and Lanstein 1985), and it was subsequently conﬁrmed to exist in other countries (Capaul, Rowley, and Sharpe 1992; Fama and French 1998; Dimson, Nagel, and Quigley 2003). While the value effect is observed regardless of which of the above-mentioned ratios is used to rank companies, the evidence suggests that the book-to-market ratio has been the most reliable (Fama and French 1992, 1996; Davis and Lee 2008). The purpose of this study is to show updated evidence from various markets on the size and value effects. Evidence on the ability of investors to time these return differences is also examined. The article concludes with a brief analysis of current market valuations.
The material in this publication is provided solely as background information for registered investment advisors, institutional investors, and other sophisticated investors, and is not intended for public use. It should not be distributed to investors of products managed by Dimensional Fund Advisors or to potential investors. This material has been distributed by Dimensional Fund Advisors Ltd which is authorised and regulated by the Financial Services Authority, Firm Reference Number 150100. Past performance is no guarantee of future results. This material is directed exclusively at professional customers as deﬁned by the FSA.
Dimensional Fund Advisors
Updated Evidence on the Size and Value Effects Table 1 shows summary statistics for the return difference between small cap and large cap indices for various countries and regions, and Table 2 shows similar results for value and growth. The average return differences in Table 1 are between 3.87% and 6.60%, while those in Table 2 are between 3.87% and 6.67%. All but one of the t-statistics on the return differences are above 2.1 The standard deviations on the return differences in Tables 1 and 2 indicate substantial variability. This can also be seen in Figures 1-6, which show the annual small-large and value-growth return differences for the UK, the US, and emerging markets. While the average size and value premiums are positive, there are some years where these asset classes underperform. Table 1
Evidence on the Size Effect
Average Annual Returns with Standard Deviations (in parentheses)
Sample Period 1956-2008
Return Denomination Pounds
Small Cap 18.85 (30.29) 15.43 (31.08) 19.33 (28.58) 19.86 (40.88)
Large Cap 14.98 (28.80) 11.31 (20.33) 12.73 (22.59) 15.70 (34.71)
Return Difference 3.87 (13.75) 4.12 (16.61) 6.60 (13.89) 4.16 (13.57)
t-Statistic on Return Difference 2.05
See Appendix for data descriptions.
Tables 1 and 2 show a tendency for value to be more volatile than growth, and they reveal a somewhat stronger tendency for small cap to be more volatile than large cap. Is it possible that the observed return differences between small and large...
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