Over the past three decades there has been a significant amount of academic research done on various “risk premiums” that appear in data on stock returns. Eugene Fama and Ken French published in 1992 what is probably the best known study identifying factors that explain stock returns over time. Their research showed that small cap stocks tend to outperform large caps, and value stocks outperform growth stocks. The so-called Fama-French three-factor model shows that these two factors, combined with market exposure, explain more than 90% of stock returns. Since the Fama-French paper was published, numerous other studies have confirmed the results and have even identified other potential factors such as momentum and liquidity.
While the existence of the small cap and value premiums is evident, the reasons why they occur is much less apparent. One school of thought proposed by efficient markets adherents is that small cap and value stocks present additional risks that result in higher returns. The primary alternative view is espoused by the behavioral finance camp, and that is that the excess returns are really anomalies resulting from investor behavior: investors tend to overvalue “glamour” companies (growth stocks) and higher market capitalizations. The question as to which theory best explains the small cap and value premiums is still up for debate.
One logical question that arises is whether these premiums should be expected to be arbitraged away over time. After all, knowing these premiums exist, wouldn’t investors bid up the prices of both small cap and value stocks such that the excess returns would disappear? Based on data obtained from Ken French’s data library, the average annualized value and small cap premiums from 7/1926 through 12/1992 (the year the Fama-French study was published) were 4.5% and 2.3%, respectively. Since that time, the premiums have declined somewhat, but still exist: from 1/1993 through 9/2013 the respective value and small cap premiums were 2.8% and 2.1%.
The table and graphs below indicate that the premiums have existed after the Fama-French research was published, so that it doesn’t appear that the anomalies are likely to be arbitraged away. One of the implications for investors is that an orientation of the portfolio toward these factors may provide superior outcomes.