In our first post, we noted that one of the main counter arguments against a size premium is the more recent empirical research which suggests the size premium has disappeared since the mid 1980’s when it was first “discovered”. We also discussed the three broad strands of research into a size premium.
Jan Loeys is Managing Director and Senior Advisor, Long Term Strategy at JP Morgan. The FT wrote a couple of articles on some of his recent comments in a client note, “The art of keeping it simple, by JP Morgan’s Jan Loeys” and “Less is more when is comes to strategic asset allocation“.
The FT quoted some of his recent client note, some of which is relevant to the Size Premium topic we have been exploring:
“Are there any superior assets left that you should systematically overweight in a strategic portfolio?
We used to think so, yes. The Empirical Finance literature has found troves of high-Sharpe ratio assets that have high returns to risk and thus lie above the standard risk-return trade-off line of local-currency bonds and global equities, which is the standard of a simple, well-diversified portfolio. If markets are perfectly open, global, and frictionless, such superior assets should not exist, because everyone will buy them, bidding up their price and pushing down their likely future return, until they have been brought down to the global risk-return trade-off line, and are no longer a superior asset class. The opposite happens for assets with inferior returns to risk as nobody will buy them, pushing down their price until they move back up in return. We thus need market inefficiencies, as we call them, typically brought on by market segmentation, to produce superior assets.
We always thought this was the Holy Grail of strategic investing. And for years, we joined the search and testing of these high-Sharpe assets, in Value, Small Caps, Momentum, High Buybacks, and Fallen Angels, to name just a few [ … ]. But it has gradually been dawning on us the last few years that the majority of these show a fading pattern of outperformance, doing well decades ago, but then not doing any better than the broad markets over the past 10 years or so. A most plausible explanation is that “everyone knows everything” nowadays and has access to the same broad Finance Literature. Academic researchers after all are paid to get their results published and not to hoard them. As all this information spread out and markets became ever more global, the excess returns on these high Sharpe assets almost all dissipated.” (our emphasis)
A Sharpe ratio (devised by Nobel prize winning William F Sharpe) divides a portfolio’s excess returns by a measure of its volatility to assess its risk adjusted performance. A Sharpe ratio of more than 1, implies outperformance.
Jan Loeys seems to sit well on the side of believing in highly efficient, frictionless markets and potentially JP Morgan and its clients are less interested in illiquid, micro-cap stocks. That said, our interpretation of Jan’s comments is that, to the extent to which “small caps” historically outperformed (a size premium), that outperformance has faded in recent years as the excess returns have been bid away as “everyone know everything” nowadays.
In his LinkedIn video on the topic he says, somewhat tongue in cheek, “If you do find something [a high Sharpe ratio asset/portfolio] it is not going to last long. If you know where it is, don’t tell me, don’t tell anybody, because it will get arbitraged away.” Jan posts regular, interesting videos on LinkedIn
As always, we are interested in any comments you may have.