Articles & Interviews
11 December 2023
The Expected Size Premium Has Never Been Higher
In the collective consciousness, there is a prevailing awareness that the trajectory of the US stock market this year has predominantly hinged on what is commonly referred to as the 'Magnificent Seven.' Investors are expressing a noteworthy concern, particularly regarding Index Concentration. Beyond the evident implication that stock market concentration signifies a lack of diversification in the idiosyncratic risk associated with large-cap names in the market portfolio, this month's research delves into the quantitative expression of this phenomenon on the Size Premium.*
The study1 commences by employing the Herfindahl-Hirschmann index to gauge the degree of concentration in the market precisely. It establishes that the concentration in the US stock market has reached levels last witnessed in 1970, marking a one-standard deviation reversal to the sample mean from the tail levels of 1995. It subsequently reveals that the Herfindahl-Hirschmann index is a positive predictor of the size premium, concluding that it rises in tandem with market concentration. To elaborate, a one-standard-deviation shift in stock market concentration results in a 9.54% annual increase in the expected size premium. Consequently, it is currently at its peak in the US, mirroring the situation in other highly concentrated markets such as Emerging ones.
Keeping an eye on the current market concentration is crucial when crafting a vibrant and well-diversified portfolio that spans regions and market capitalisation segments. It serves as a key factor in deciphering the potential premiums that can be reaped in the future.
*The Size Premium is defined as the tendency of relatively low market capitalisation to earn superior returns than firms with relatively high market capitalisation.
1Emery, L. P., & Koëter, J. (2023). The size premium in a granular economy. Social Science Research Network. https://doi.org/10.2139/ssrn.4597933
Junior Investment Analyst
The figures, comments, opinions and/or analyses contained herein reflect the sentiment of RAM with respect to market trends based on its expertise, economic analyses and the information in its possession at the date on which this document was drawn up and may change at any time without notice. They may no longer be accurate or relevant at the time of reading, owing notably to the publication date of the document or to changes on the market.
This document is intended solely to provide general and introductory information to the readers, and notably should not be used as a basis for any decision to buy, sell or hold an investment. Under no circumstances may RAM be held liable for any decision to invest, divest or hold an investment taken on the basis of these comments and analyses.
RAM therefore recommends that investors obtain the various regulatory descriptions of each financial product before investing, to analyse the risks involved and form their own opinion independently of RAM. Investors are advised to seek independent advice from specialist advisors before concluding any transactions based on the information contained in this document, notably in order to ensure the suitability of the investment with their financial and tax situation.
Past performance and volatility are not a reliable indicator of future performance and volatility and may vary over time, and may be independently affected by exchange rate fluctuations.