We recently published an article on S&P’s Indexology blog that looks at some of the more practical aspects of harvesting the size premium – a premium earned by owning smaller stocks.

In our U.S. Factor Defensive Equity strategy, we hold ETFs that aim to capture premiums from value, size, momentum, dividends, and low volatility. Of these five, the size premium is generally the weakest and has come under fire over the past few decades for not being a legitimate premium in the first place.

In academic research, these risk premiums are studied using the returns of a long-short portfolio; for example, the size factor return would look at a portfolio that is long small-cap stocks and short large-cap stocks. In this way, the factor return can still be positive when small-cap stocks decline, as long as they decline less than large-cap stocks.

From this description, we can see that the factor return is highly dependent on how we define small-cap and large-cap and how we weight the portfolio. The size factor (Small minus Big or SMB) outlined by Fama and French is defined in a specific way.  However, these so-called pure factor premiums are difficult for the average investor to obtain, especially in light of transaction costs, fees, and liquidity constraints.

In our strategy, we focus on long-only ETFs that are tilted toward the desired factors. The central theme of the Indexology article is that there is more than one way to skew toward smaller capitalization stocks. Because our strategy focuses on risk-adjusted factor returns, simply investing in a small-cap index ETF might not achieve our objectives if it does not earn a risk-premium as opposed to just a premium that is commensurate with its higher risk.

For the size factor, we choose to use the S&P 500 Equal Weight ETF (RSP). Its equal weighting skews it toward smaller stocks while also giving it a tilt away from glamour stocks. Its rebalancing back to equal weight allows it to capture some of the benefits of short-term mean reversion, and because it is based upon larger companies, we expect it be exposed to the quality factor, which has been shown by AQR to be a determinant in constructing a robust size factor.

Check out the article and let us know what you think. We love getting feedback on our decisions and especially enjoy when those questions push us into new realms of research.

Nathan is a Portfolio Manager at Newfound Research, a quantitative asset manager offering a suite of separately managed accounts and mutual funds. At Newfound, Nathan is responsible for investment research, strategy development, and supporting the portfolio management team. Prior to joining Newfound, he was a chemical engineer at URS, a global engineering firm in the oil, natural gas, and biofuels industry where he was responsible for process simulation development, project economic analysis, and the creation of in-house software. Nathan holds a Master of Science in Computational Finance from Carnegie Mellon University and graduated summa cum laude from Case Western Reserve University with a Bachelor of Science in Chemical Engineering and a minor in Mathematics.