Are Size and Momentum economically significant in international stock markets

"This paper investigates the interplay between size and momentum strategies in international stock markets. A main focus of our work is to determine if any size and momentum profits are indeed realizable in the practical implementation of investment strategies or whether they have to be deemed illusory. Our analysis is motivated by the fact that researchers and practitioners alike are increasingly eager to determine the existence or non-existence of equity market anomalies across the globe. Besides allowing for an analysis of the common roots of a specific anomaly, relying on international data can help address a common objection that anomalies observed in the US market alone may possibly be a manifestation of survivorship or data-snooping biases

For both size and the momentum strategies, it is critical from a practical perspective to also develop a sense of the feasibility of these strategies once trading costs and market depth are taken into account.

Our main results on the profitability of size and momentum are as follows. First, we do not find a significant size effect for any of the countries covered, when judged by the average return on the SMB factors. However, Banz (1981) already suggested that “the size effect is not linear in the market value; the main effect occurs for very small firms while there is little difference in return between average sized and large firms” (p. 3). Consequently, we consider an “extreme” size effect, namely, the difference in stock returns between the biggest 10% (in terms of market capitalization) and the smallest 10%. We find that the size effect (not adjusted for trading costs), when defined this way, appears to be alive and well in most of the countries we consider. Indeed, it also exists in many countries when considering the smallest and largest quintiles. In a related study, De Moor and Sercu (2013) find in a pooled international dataset that the smallest 10% of the firms earn a significant premium over the biggest 10 % firms. Our study first differs from theirs in that we examine various countries separately, allowing additional insights. Moreover, we use value weighted, instead of equal-weighted returns. Most importantly, as discussed below, we also evaluate the trading costs and the actual implementability of size-based trading strategies.

Next, we investigate the interplay between size and momentum. Hong et al. (2000) find for US data from 1980 to 1996 that “… once one moves past the very smallest capitalization stocks (…) the profitability of momentum strategies declines sharply with market capitalization” (p. 267). Our results for the international dataset from 1991 to 2012, constituting an out-of-sample test, confirm this finding for many individual countries. Our results are also in line with the results of Chui et al. (2010) who show that momentum profits across the world are negatively related to the median firm size in the respective markets. In contrast, we do not find support for the claim of Avramov et al. (2013) that momentumstrategies derive their profitability from shorting loser stocks. Moreover, we find a significant size premium for a portfolio containing the 30% of stocks with the highest degree of momentum (i.e. the highest past 2-12 month average returns).

Importantly, we examine whether these size and momentum strategies are still worthwhile when trading costs are included in the analysis. This is rarely done in academic studies but has received attention in the current literature (e.g. Frazzini et al., 2012; Novy-Marx and Velikov, 2014). We employ three approaches. First, we directly approximate trading costs by values based on Frazzini et al. (2012). Second, we compute critical (maximum) trading costs that an investor could occur and still earn significant excess returns. Third, we calculate the US dollar trading volume of the involved portfolios to assess whether the market has enough depth and capacity for such a quantitative strategy to be implementable in practice.

We find that size premiums, even where they exist, are most likely not realizable because the US dollar trading volumes of the involved portfolios are rather small. Momentum premiums are also diminished by trading costs to a considerable extent. That said, for most countries momentum premia still remain statistically and economically significant, especially for medium-sized stocks."

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