The small-capitalization stocks premium (size effect) is one of the few effects which is accepted by nearly the whole academic community. It says that low capitalization stocks earn substantial premiums against stocks with large capitalization (without additional risk). This anomaly is the best described in the classical Fama and French research paper (1993). Additional details are calculated from data that are present in the Kenneth French data library (http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html).
Pure small-cap effect portfolios are created as long stocks with the lowest capitalization and short stocks with the largest capitalization. However, this pure small-cap effect had disastrous drawdowns with nearly 80% drawdown in the 90s. The small-cap factor is, however, still a strong performance contributor in long-only portfolios (formed as long stocks with the smallest capitalization without shorting large caps).
The size effect can be explained by the illiquidity of small companies, mainly as a result of higher trading costs.
The effect could also be caused by bigger space to grow for smaller companies, their greater flexibility during the business cycle, and higher inside innovation, which gives small-caps an advantage against large-cap stocks. Another explanation for this effect is simply higher risk involved in small-cap companies.
Confidence in anomaly's validity
Backtest period from source paper
Notes to Confidence in Anomaly's Validity
Period of Rebalancing
Notes to Indicative Performance
per annum, benchmark performance 9,79%
Notes to Period of Rebalancing
Number of Traded Instruments
Notes to Estimated Volatility
benchmark volatility 20,10%
Notes to Number of Traded Instruments
more or less, it depends on investor’s need for diversification
Notes to Maximum drawdown
benchmark drawdown -85,67%
Notes to Complexity Evaluation
Simple trading strategy
The investment universe contains all NYSE, AMEX, and NASDAQ stocks. Quintile portfolios are then formed based on the market capitalization of stocks, and the lowest quintile (stocks weighted based on market cap.) is held for one year, after which the portfolio is rebalanced.
Hedge for stocks during bear markets
No - Small-cap stocks are not a good hedge/diversification during times of stress, they perform well after economic crises (see for example research paper by Bansal, Connolly, Stivers: “High Risk Episodes and the Equity Size Premium”), but they perform really bad during times leading up to it (when they are often one of the most damaged market segment).
Strategy's implementation in QuantConnect's framework