An Old Idea That’s New Again
The question, of course, is whether the results are just data mining and therefore destined to end up as another asset-pricing anomaly that stumbles as an actual portfolio. The answer to that might lie with the father of modern securities analysis and value investing’s original guru: Ben Graham.

The strategy of buying undervalued stocks is enshrined in the classic book Security Analysis, which Graham and co-author David Dodd published in 1934. If you read this iconic text, which inspired several generations of money managers, you’ll also notice an emphasis on value and quality.

Graham continued to focus on these two aspects of stock selection through the years. In his best seller geared for the general public, The Intelligent Investor, he reminded readers that “a stock does not become a sound investment merely because it can be bought at close to its asset value.” The qualitative factor must be considered too, he added, recommending that “the investor should demand … a satisfactory ratio of earnings to price, a sufficiently strong financial position and the prospect that its earnings will at least be maintained over the years.”

Or as Warren Buffett—Graham’s most-famous and successful disciple—reportedly explained some years ago: “I try to buy stock in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will.”

The ability to avoid the idiots, so to speak, is an honored skill in investing, and it’s especially crucial in the realm of small caps, according to Asness and co-authors. That’s hardly surprising, or at least it shouldn’t be. As “Size Matters” explains, large companies “tend to be high quality firms … while small firms tend to be ‘junky.’” That’s a reminder that filtering out the low-quality stocks among small caps is essential to reliably capturing the premium associated with them.

Yes, But …
The case for quality small caps suggests that there might be a major rethink about indexing in this market niche. A no-brainer, right? Not so fast, says Joel Dickson, global head of investment research and development at Vanguard. “It’s just another strategy,” he says. In fact, it’s one that’s already in use to a degree at his firm. “At Vanguard, we have some quant funds that incorporate quality approaches into their selection of securities.”

In any case, Dickson doesn’t see it as a game-changer for rewiring small-cap indexing. “Once you say we can outperform traditional small-cap indexes, then it’s active risk.” In turn, that opens the door for higher turnover and higher fees than you’d find in plain-vanilla passive products.

Fair enough, but it’s going to be hard to put this genie back in the bottle, says Phil DeMuth at Conservative Wealth Management in Los Angeles. “It’s just a question of time before they integrate it,” predicts DeMuth, author of the book The Affluent Investor and other titles. After reading the paper, he thinks that there’s opportunity for enhancing the choices in the small-cap arena with a new line of products. “AQR will probably be first on the block; Dimensional [Fund Advisors], too, eventually. They’ll all end up using quality plus small cap going forward.”

There may be some disruption coming to the small-cap-value realm too. The “Size Matters” paper doesn’t invalidate the value research that’s been widely embraced over the years. But the paper sheds a bit more light on why expected returns are comparatively high in this corner of the equity market.

“If you combine value and quality, you’d have a stronger portfolio than if you just look at value on a stand-alone basis,” says AQR’s Israel. “Quality helps to hone in on the cheap stocks that are cheap for a good reason.”

As for the high-quality small caps that fit the bill, the choices are still generally determined by the subjective views of active managers and perhaps a handful of so-called smart-beta products.

With index funds, it depends. Consider, for instance, the iShares Core S&P Small-Cap, an ETF that hugs the S&P SmallCap 600, and the iShares Russell 2000, which tracks the Russell 2000. According to AQR’s figures, the former is more exposed to high-quality small-cap names. When we run the two ETFs through a multi-factor-analysis grinder, we see that not all index funds are created equal when it comes to grabbing a piece of the high-quality small caps. Analyzing the funds through the prism of AQR’s figures reveals that the S&P-based fund’s beta for high-quality small caps was roughly 0.60 while the Russell fund’s was 0.34.

Does the difference explain why the former outperformed the latter by a healthy margin over the past five years? There are no absolutes in asset pricing, but given the historical record in the “Size Matters” paper, it would be surprising if the answer wasn’t closely linked with the high-quality small-cap factor.
 

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