The Size Factor: Why Small-Cap Stocks Outperform Large-Caps Over Time
From 1926-2023, small-cap stocks returned 12% annually vs large-cap's 10%. But small caps had higher volatility (30% vs 17%) and longer periods of underperformance. From 2013-2023, small caps actually underperformed large caps. Here's how the size factor works.
The size factor (also known as the small-cap premium) is the tendency for stocks with smaller market capitalizations to outperform stocks with larger market capitalizations over the long term. This anomaly was first documented by Rolf Banz in 1981 and became one of the three factors in the Fama-French three-factor model (1993). The size effect is most pronounced among the smallest companies — micro-caps (below $300 million) have historically shown the largest premium. The economic intuition is that small companies are riskier — they have less access to capital, less diversified revenue streams, thinner management teams, and lower liquidity. Investors demand a higher expected return for bearing these risks. However, the size premium has been controversial in recent decades, as it has weakened significantly since its discovery. Some researchers argue the premium only exists among small-cap value stocks rather than small caps generally. Complete factor investing overview →
Key numbers: From 1926-2023, small-cap stocks (bottom decile by market cap) returned 12.0% annually vs large-cap stocks (top decile) at 10.0% — a 2% small-cap premium. The premium was strongest from 1926-1983 (approximately 4% annually) and weakest from 1984-2023 (approximately 0.5% annually). Small-cap volatility averages 30% vs 17% for large caps. The Russell 2000 (small-cap index) has a beta of approximately 1.1 relative to the S&P 500. Small caps have had 8 distinct periods of outperformance and 7 periods of underperformance since 1926, with cycles lasting 3-10 years on average. Detailed comparison of small cap vs large cap →
How the Size Factor Is Measured
The size factor (SMB — Small Minus Big) is constructed by sorting stocks by market capitalization and going long the smallest stocks and short the largest stocks. Fama and French use the median NYSE market cap as the breakpoint. Stocks below the median are "small," stocks above are "big." The SMB return is the average return of small-cap portfolios minus the average return of large-cap portfolios. The most commonly used small-cap index is the Russell 2000, which tracks the smallest 2,000 stocks in the Russell 3000 index (approximately $300 million to $2 billion market cap). The S&P 600 is another popular small-cap index that applies additional liquidity and profitability screens. The CRSP US Small Cap Index is used by Vanguard's VB ETF. The size premium is strongest in January (the January effect), possibly due to tax-loss harvesting and year-end portfolio adjustments. The premium is also stronger among micro-caps (below $300 million) than among standard small caps ($300 million to $2 billion). Understanding market cap size classifications →
Why the Size Premium Has Weakened
The size premium has diminished significantly since the early 1980s. Several explanations have been proposed. Discovery effect: once the size premium was documented and became widely known, investors piled into small-cap strategies, arbitraging away the premium. The proliferation of small-cap ETFs and mutual funds made it easier to invest in small caps, potentially reducing the return premium. Changes in the economy: the US economy has shifted from manufacturing (where small companies could thrive) to technology and services (where scale advantages are more significant). Tech giants like Apple, Microsoft, and Amazon dominate the large-cap space in ways that earlier generations of large companies did not. Listing bias: the universe of publicly traded companies has changed. There are fewer small public companies today due to consolidation, private equity, and the costs of being public. The companies that remain small may be lower quality than historical small caps. The size premium remains strongest among profitable small companies — small-cap value stocks with high profitability (like those targeted by AVUV) have shown a more robust premium than small caps generally. In-depth guide to small-cap investing →
Capturing the Size Factor Through ETFs
The simplest way to capture the size factor is through broad small-cap ETFs. IWM (iShares Russell 2000 ETF, 0.19% ER) tracks the Russell 2000 and is the most traded small-cap ETF. VB (Vanguard Small-Cap ETF, 0.04% ER) tracks the CRSP US Small Cap Index and is the cheapest option. IJR (iShares S&P Small-Cap 600 ETF, 0.06% ER) tracks the S&P 600, which applies profitability screens. For stronger size exposure, consider AVUV (Avantis US Small Cap Value ETF, 0.25% ER), which targets small-cap value — the intersection of size and value that has historically had the strongest premium. AVDV (Avantis International Small Cap Value ETF, 0.36% ER) provides international small-cap value exposure. The size factor is best combined with value. Small-cap value (size + value) has historically produced the highest returns of any factor combination. A simple size allocation: 10-20% of equity in AVUV or VB. Small-cap ETFs have higher expense ratios than large-cap ETFs but are still inexpensive relative to active management. Factor ETF comparison and recommendations →
What is the size factor?
The size factor (SMB) is the tendency of small-cap stocks to outperform large-cap stocks over time. First documented by Rolf Banz (1981) and included in the Fama-French three-factor model (1993). Small caps returned 12% annually vs large caps' 10% from 1926-2023, but the premium has weakened since the 1980s.
Why has the small-cap premium weakened?
The premium has weakened due to discovery and arbitrage by investors, structural changes in the economy favoring large tech companies, fewer small public companies, and index inclusion effects. The premium remains strongest among small-cap value stocks (size + value combination).
How do you capture the size factor?
Invest through small-cap ETFs like IWM (Russell 2000), VB (CRSP Small Cap), or AVUV (small-cap value). Allocate 10-20% of equity to small caps. Combine small-cap value (AVUV) with core large-cap holdings. Small-cap ETFs have higher expense ratios but remain cost-effective.
Is the size factor dead?
The size factor is not dead, but it has underperformed large caps for extended periods. From 2013-2023, large caps significantly outperformed small caps. However, small-cap value has continued to show a premium. The size factor is cyclical and requires patience through underperformance periods.
Related Resources
Small-Cap Investing Guide
How to invest in small-cap stocks and capture the size premium.
Factor Investing Guide
Overview of all major investing factors including size.
Factor Investing ETFs
Specific ETFs for capturing size and other factors.
The Value Factor
Value combines with size for the strongest factor premium.
Small Cap vs Large Cap
Detailed comparison of small-cap and large-cap investing.
Small Cap vs Mid Cap vs Large Cap
Understanding market cap size classifications.