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Size factor

The historical tendency for smaller companies to outperform larger ones, and the risk and liquidity characteristics that come with owning them.

Measured as the return of small-cap portfolios minus large-cap portfolios, the size premium was one of the earliest documented anomalies. Later work found much of it concentrated in the smallest, least liquid and least profitable names, and in January returns, which weakened the case considerably.

Small caps carry real costs that averages hide: wider spreads, thinner depth, higher borrow costs, and greater sensitivity to funding conditions. A backtest computed on closing prices can overstate an achievable premium by a large margin once slippage is charged.

Size still matters as a portfolio descriptor even where its premium is doubted, because it drives much of the difference between a cap-weighted and an equal-weighted-index, and it interacts strongly with quality-factor.

Related: factor-investing, equal-weighted-index, quality-factor, market-cap, slippage, fama-french-three-factor

See it drawn

Original diagrams for the ideas on this page. Illustrative, not real market data.

Slippage on a market orderA buy order clears four price levels, so the average price paid is worse than the price first quoted.Buy 1,000 shares at marketpricesell orders resting (bar length = size)20.04300 shares20.03200 shares20.01200 shares20.00300 sharesnothing resting at 20.02order sweeps up the bookaverage fill 20.02SLIPPAGE0.02 a share$20.00 in totalintended 20.00Each level fills at its own price; the average is what you really paid.
Slippage on a market order. You click at 20.00, but only 300 shares are resting there, so the rest of the order fills at 20.01, 20.03 and 20.04. The average price paid is 20.02, and that two-cent gap is slippage.

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