Small and Lightly Followed Stocks

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The persistence of the small stock premium has led many to argue that what looks like a premium in studies comes the failure to allow for transactions costs and to adequately measure risk in firms. There is truth in these arguments, though it is unclear whether the small stock premium would disappear even if they were considered.

Transactions Costs

The transactions costs of investing in small stocks are significantly higher than the transactions costs of investing in larger stocks. The bid-ask spread as a percent of the stock price is higher for smaller companies. In addition the price impact from trading is also higher for small cap stocks because they are less liquid; you will tend to drive the price up as you buy and down as you sell, especially with larger orders. Can the difference in transactions costs overwhelm the small cap premium? The answer has to depend upon both the size of your portfolio and your time horizon. With short time horizons, the transactions costs can wipe out any perceived excess returns associated with small cap companies, With longer time horizons, though, you can spread the costs over your holding period and the excess returns may persist. A larger portfolio can help you reduce some transactions costs (brokerage and commission costs) but may increase other transactions costs (price impact).

In a telling illustration of the difficulties associated with replicating the small firm premiums that are observed in the research in real time, the returns on a hypothetical small firm portfolio (CRSP Small Stocks) are compared with the actual returns on a small firm mutual fund (DFA Small Stock Fund), which passively invests in the same small stocks in Figure 9.10:

Figure 9.10: Returns on CRSP Small Stocks versus DFA Small Stock Fund

Every year, the retain on the DFA fmd have lagged the return* on the paper portfolio (CRSP »mail stock»).

Figure 9.10: Returns on CRSP Small Stocks versus DFA Small Stock Fund

Every year, the retain on the DFA fmd have lagged the return* on the paper portfolio (CRSP »mail stock»).

DFA Small Fiim Ftand

Data from Morniingstar and CRSP. The returns in each year from the DFA mutual fund and from the hypothetical small stock portfolio of CRSP are reported.

DFA Small Fiim Ftand

Data from Morniingstar and CRSP. The returns in each year from the DFA mutual fund and from the hypothetical small stock portfolio of CRSP are reported.

Note that the returns on the DFA fund consistently lag the returns on the hypothetical portfolio by about 2%, reflecting the transactions and execution costs faced by the fUnd.

Consider now the lightly followed, small cap portfolio in table 9.9. While only stocks with a price of more than a dollar were considered for this portfolio, there are a large number of low priced stocks in the portfolio. In Figure 9.11, the stocks in the portfolio are broken down by the level of the stock price:

Figure 9.11: Stock Prices in Small Cap Portfolio

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