SMB factor, also known as the size factor, is one of the most important factors in the Fama-French three factor model. It represents the excess return that small market capitalization stocks have over big market capitalization stocks. The SMB factor investment strategy has been widely used by practitioners in stock selection and portfolio construction. This article will introduce the research origin, construction method and application of the SMB factor investment strategy, hoping to help investors better understand SMB investments.
The theoretical origin of SMB factor in the Fama-French three factor model
The theoretical origin of the SMB factor can be traced back to the famous Fama-French three factor model (Fama and French, 1993). Through empirical research on the US stock market, Eugene Fama and Kenneth French found that market beta alone can not explain the cross-section of stock returns, but company size and book-to-market ratio have significant explanatory power on returns. Therefore, they constructed two additional factors – SMB and HML, together with the market factor, formed the renowned Fama-French three factor model. Specifically, SMB represents the excess return of small-cap stocks over big-cap stocks, indicating that small-cap stocks outperform big-cap stocks even after adjusting for market risk.
The construction of SMB factor investment portfolio
There are several methods to construct the SMB factor investment portfolio. The most common method is the double sorting approach used by Fama and French (1993). At the end of each June, all stocks are sorted into two groups based on the median market cap. Big group contains the top 50% biggest stocks, small group contains the bottom 50% smallest stocks. Then the two groups are further divided into three subgroups respectively based on the 30th and 70th percentile breakpoints of book-to-market ratio. Finally, the SMB portfolio is constructed by taking the average return of the three small subgroups minus the average return of the three big subgroups.
The application of SMB investments in quantitative strategies
The SMB factor has been widely used in quantitative investment strategies and smart beta ETFs for its ability to generate excess returns. For example, in long-only equity strategies, investors can tilt the portfolio weights towards small-cap, high SMB factor exposure stocks to harvest the size premium. In 130/30 strategies, investors can long small-cap stocks and short big-cap stocks at the same time. There are also SMB focused smart beta ETFs like iShares Russell 2000 ETF (IWM) which tracks the Russell 2000 small-cap index. Overall, the SMB factor is an important piece in the toolkit of quantitative investors.
The empirical performance and risks of SMB investments
Although historically, the SMB factor earned significant excess returns over the market, its performance is not consistent over time. Empirical research shows that SMB experienced prolonged periods of underperformance and high volatility. For example, during the tech bubble period of late 1990s, small-cap stocks severely lagged big-cap growth stocks. Investors should be aware of its cyclicality while utilizing SMB in their investment process. Furthermore, transaction costs should also be taken into consideration due to the high turnover nature of certain SMB strategies.
In summary, the SMB factor represents the excess returns of small-cap stocks versus large-cap stocks. It originated from academic research and has been widely used by practitioners in equity investment strategies. However, the empirical performance of SMB is not stable over time and can suffer from periods of underperformance. Investors should be cautious of its risks while harnessing SMB for higher expected returns.