The smb investing strategy has become increasingly popular in recent years. By targeting small and medium-sized companies, investors can take advantage of the size effect and generate excess returns. However, there are also risks associated with smb investing that need to be managed carefully. In this article, we will explore the rationale, implementation, and risks of the smb investment strategy.
Size effect provides basis for smb investing strategy
The size effect refers to the empirical observation that small-cap stocks tend to outperform large-cap stocks in the long run. Extensive academic research has confirmed the existence of the size premium, meaning small-cap stocks earn higher risk-adjusted returns compared to large-cap stocks. The smb investing strategy aims to systematically buy small-cap value stocks and short sell large-cap growth stocks to capture this size premium.
Constructing an smb portfolio based on market cap
A simple way to implement the smb strategy is to rank all stocks by market capitalization and go long the bottom 10% (small-cap) while shorting the top 10% (large-cap). More sophisticated implementations may incorporate factors like book-to-market ratio and trailing returns. The portfolio is rebalanced periodically, such as quarterly or annually, to maintain exposure to the desired size segment.
Controlling risks associated with small-cap investing
While small-cap stocks offer higher expected returns, they tend to be more volatile with higher bankruptcy risk. Constructing a diversified basket of small-cap stocks can help mitigate individual stock risk. Investors should also pay close attention to liquidity to avoid being stuck in an illiquid position. Implementing prudent position sizing, stop losses, and disciplined rebalancing can help manage the risks.
Size factor has time-varying returns
Like other factors, the size premium does not generate excess returns at all times. During periods of large-cap outperformance, smb investing may underperform. Investors should be aware of these cyclical dynamics and adjust exposure accordingly. Combining smb with other factors like value and momentum can improve consistency of returns.
The smb investing strategy offers a systematic approach to target excess returns from the size factor. By tilting towards small-cap stocks, investors can benefit from the historically observed size premium. However, the size effect is not consistent, and these stocks carry greater risks. Awareness of the cyclicality and prudent risk management allows investors to effectively implement this strategy as part of a diversified portfolio.