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Fact, Fiction, and the Size Effect Analysis

Last Updated on 10 February, 2024 by Rejaul Karim

The paper entitled “Fact, Fiction, and the Size Effect” explores the enduring enigma of the size effect, a pioneering discovery in empirical academic finance that stirred debates about market efficiency and challenged the standard asset pricing model. Authored by Ron Alquist, Ronen Israel, and Tobias J. Moskowitz, this 54-page analysis, last revised in August 2018, delves into the conventional wisdom that small stocks yield higher average returns than large stocks, even after risk-adjustment.

This groundbreaking revelation has significantly influenced investment practices, spawning a proliferation of small-cap indices and active funds that led to the segmentation of the investment landscape into large and small stock universes.

Nevertheless, despite its widespread acceptance and enduring history, confusion and debate continue to shroud the size effect.

The authors endeavor to unravel this ongoing conundrum by subjecting various claims and misunderstandings about the size effect to simple tests using publicly available data.

Abstract Of Paper

In the earliest days of empirical work in academic finance, the size effect was the first market anomaly to challenge the standard asset pricing model and prompt debates about market efficiency. The notion that small stocks have higher average returns than large stocks, even after risk-adjustment, was a pathbreaking discovery, one that for decades has been taken as an unwavering fact of financial markets. In practice, the discovery of the size effect fueled a crowd of small cap indices and active funds to a point where the investment landscape is now segmented into large and small stock universes. Despite its long and illustrious history in academia and its commonplace acceptance in practice, there is still confusion and debate about the size effect. We examine many claims about the size effect and aim to clarify some of the misunderstanding surrounding it by performing simple tests using publicly available data.

Original paper – Download PDF

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Author

Ron Alquist
Financial Stability Oversight Council, U.S. Treasury

Ronen Israel
AQR Capital Management, LLC

Tobias J. Moskowitz
Yale University, Yale SOM; AQR Capital; National Bureau of Economic Research (NBER)

Conclusion

Diving deep into the annals of academic finance, “Fact, Fiction, and the Size Effect” concludes with a compelling testament to the enduring enigma of the size effect. This pioneering anomaly, which ignited fervent debates about market efficiency, has persisted as a momentous discovery over decades.

The perennial notion that small stocks yield higher average returns than large stocks, even after risk adjustment, altered the investment landscape, giving rise to a surfeit of small-cap indices and active funds. Despite its pervasive acceptance and illustrious academic history, clarity and consensus on the size effect remain elusive.

The authors’ comprehensive examination of various claims and misunderstandings surrounding the size effect, through simple tests using publicly available data, serves as a pivotal step toward demystifying this longstanding conundrum.

In doing so, this study sheds light on the enigmatic interplay of size, market efficiency, and liquidity, offering a compelling contribution to the continuing discourse on the size effect and its implications in financial markets.

Related Reading:

The Size Effect Continues to be Relevant When Estimating the Cost of Capital

Micro Uncertainty and Asset Prices

FAQ

What is the main focus of the paper “Fact, Fiction, and the Size Effect” by Ron Alquist, Ronen Israel, and Tobias J. Moskowitz?

The main focus of the paper is to explore and examine the enduring enigma of the size effect, which is the notion that small stocks yield higher average returns than large stocks, even after risk adjustment. The authors delve into the history, acceptance, and ongoing confusion and debate surrounding the size effect, subjecting various claims and misunderstandings to simple tests using publicly available data.

How has the size effect influenced investment practices and the segmentation of the investment landscape?

The size effect, revealing that small stocks have higher average returns than large stocks, has significantly influenced investment practices. It led to the proliferation of small-cap indices and active funds, contributing to the segmentation of the investment landscape into large and small stock universes. This influence has had a lasting impact on investment strategies and market segmentation.

What does the paper aim to achieve by examining claims and misunderstandings about the size effect?

The paper aims to clarify and address the ongoing confusion and debate about the size effect. By subjecting various claims and misunderstandings to simple tests using publicly available data, the authors seek to unravel the complexities surrounding the size effect. The goal is to provide insights that contribute to a better understanding of the size effect and its implications in financial markets.

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