What is the Size Factor?
Core Principle
The Size factor systematically tilts portfolios toward smaller market capitalization companies, which academic research suggests may provide superior long-term returns compared to large-cap stocks.Market Cap Context: Smaller companies like a $500M small-cap stock behave differently than $500B mega-cap giants. This size difference can translate into higher potential returns for investors willing to hold over longer time horizons.
Why Size May Work
Several mechanisms may drive size premiums:- Market Inefficiency: Smaller companies receive less analyst coverage and institutional attention
- Liquidity Premium: Investors demand higher returns for less liquid small-cap stocks
- Growth Potential: Smaller companies may have more room for business expansion
- Behavioral Factors: Institution size constraints create opportunities for smaller funds
Size Factor Evolution
Historical Performance
- Academic Evidence
- Performance Periods
- Implementation Challenges
Original Research: Banz (1981) documented small-cap outperformance 1936-1975Fama-French Model: Size factor became cornerstone of three-factor model (1993)Global Evidence: Size premiums documented across international marketsAsset Class Breadth: Size effects observed in REITs, bonds, and other asset classes
Modern Size Implementation
Refined Size Definitions
Rather than simple market cap rankings, sophisticated size implementation considers:Adjusted Market Cap
Float-Adjusted: Only tradeable shares, excluding insider holdingsLiquidity-Weighted: Emphasize stocks with adequate trading volumeRegional Context: Size relative to local market rather than global absolute
Quality-Adjusted Size
Profitable Small Caps: Focus on profitable rather than unprofitable small companiesFinancial Strength: Screen for adequate balance sheet qualityAvoid Distress: Exclude companies with high bankruptcy risk
Sector Considerations
Technology Emphasis: Growth-oriented sectors where size may provide advantagesAvoid Capital-Intensive: Industries where scale provides significant cost advantagesRegional Champions: Local market leaders that haven’t scaled globally
Implementation Efficiency
Liquidity Thresholds: Minimum trading volume requirementsSize Bands: Smooth transitions rather than hard cutoffsCost Analysis: Balance factor exposure with transaction costs
Risk Considerations
Size Factor Risks
Higher Volatility: Small-cap stocks typically exhibit higher individual and portfolio volatility Liquidity Risk: Reduced ability to quickly enter or exit positions Economic Sensitivity: Small companies often more sensitive to economic cycles Quality Dispersion: Wider range of business quality among smaller companiesRisk Management Approaches
- Diversification
- Quality Screens
- Liquidity Management
Broad Holdings: Maintain exposure across many small-cap names to reduce single-stock riskSector Diversification: Avoid concentration in cyclical or speculative sectorsGeographic Spread: Include small caps from multiple regions for additional diversificationSize Spectrum: Include mid-caps along with small caps for smoother risk profile
Parallax Size Implementation
Multi-Dimensional Approach
Our Size factor implementation incorporates: Size-Quality Combination: Emphasis on profitable, growing small companies rather than distressed situations Liquidity Optimization: Balance size exposure with practical implementation considerations Regional Customization: Size definitions adapted to local market characteristics Cost-Conscious Execution: Minimize transaction costs while maintaining factor exposureFactor Integration
Size works best when combined with other factors:Size + Quality: High-quality small companies reduce bankruptcy risk while maintaining growth potentialSize + Value: Undervalued small companies may offer the best of both factorsSize + Momentum: Small companies with positive trends often continue outperforming
Size Factor Across Market Environments
When Size Outperforms
Economic Recovery: Small companies often have more operational leverage during expansions Risk-On Environments: When investors embrace risk, small caps typically benefit Value Cycles: Small caps often have more value characteristics than large caps Rising Rate Environments: Small caps may benefit from steepening yield curvesWhen Size Underperforms
Market Stress: Flight to quality typically favors large, stable companies Liquidity Crunches: Reduced liquidity disproportionately affects small caps Growth Markets: When growth dominates, mega-cap growth stocks often lead International Headwinds: Small caps typically more domestically focusedImplementation Considerations
Portfolio Construction
- Position Sizing: Smaller individual positions due to higher volatility
- Rebalancing Frequency: Less frequent rebalancing to manage costs
- Liquidity Reserves: Maintain adequate liquidity for portfolio changes
- Risk Budgeting: Appropriate risk allocation given higher volatility
Cost Management
- Transaction Cost Analysis: Model impact of trading costs on net returns
- Timing Optimization: Strategic timing of rebalancing activities
- Cross-Trading: Internal crossing to reduce market impact
- Algorithm Usage: Sophisticated execution algorithms for larger trades
Explore how Size combines with other factors in our Factor Implementation, or dive into Quality Factor investing to understand complementary approaches.