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Size Factor vs. Monetary Policy Regime

Size Factor vs. Monetary Policy Regime

Posted January 30, 2023 at 4:14 pm


We have brought attention to the importance of evaluating factors models in different market regimes, and now, we will take a closer look at the size factor. Size [SMB (small minus big)] factor is a popular investment choice for asset investigation by many portfolio managers worldwide. The Size earned prominence in Fama and French‘s three and five-factor models and enjoy the continued discussion about its place in today’s portfolio construction.

In their paper, Simpson and Grossmann (Sep 2022) make many calls to the research of Asness et al. (2018). They use the classification of subsamples for evaluation of size factors as the “Golden Age” (1957-1979), the “Embarrassment” period (1980-1999), and the “Resurrection” period (2000-2012), which helps to bring some light into when the Size is performing the best. Basically, they find that without controlling for Quality, there is a size effect in the Golden Age and the Resurrection period but not in the Embarrassment period. After controlling for firm Quality, however, they document a significant Size premium in all three periods. But is that really? And what may be the underlying forces behind these occurrences?

While nodding to previous research and acknowledging it, the authors challenge it and partly disagree while offering a demonstration that the size premium re–emerges whether or not one controls for Quality if one examines the monetary policy stance and stringency being followed by the Federal Reserve. Functions of monetary policy and liquidity in markets are the most important for these smaller companies that enjoy loosened financial conditions, cheap capital, and credit. In every period and subperiod, they find significant premiums for the SMB factor during periods of monetary easing with and without controlling for firm Quality; while there are no observations of significant premiums for the SMB factor during any period of monetary tightening, even if one controls for Quality.

We can conclude that choosing Quality among smaller firms during restrictive monetary periods and conditions will probably not contribute to and secure fine results. It would be crucially important for investors seeking to capture the Size premium to realize that it is dependent on the monetary policy being pursued by the Federal Reserve, as the monetary easing seems to induce a Size premium.

Authors: Marc William Simpson and Axel Grossmann

Title: The Resurrected Size Effect Still Sleeps in the (Monetary) Winter


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