Size and Value Effect based Portfolio Strategies:
The ‘size effect’ follows from the findings of Rolf Banz which stated that small stocks have consistently outperformed large stocks since 1926. DFA created “small stock” funds by making a portfolio of stocks whose market capitalization fell below a cut-off set by a certain percentile of all exchange stocks. For e.g., DFA created small stock portfolios such as ‘US Micro Cap’ Portfolio containing stocks whose market cap was below the cut-off set by 20th percentile of NYSE. DFA also introduced similar small stock funds on International Exchanges of UK, Japan and Europe based on the research that indicated size effect in these geographies also. ‘Value effect’ refers to the fact that firms which have a higher book value of equity to market value of equity ratio (BE/ME), known as ‘value stocks’ tend to outperform the firms with lower BE/ME ratio, called as ‘growth stocks’. This idea, proposed by Fama and French with solid empirical evidences, was based on the fact that by taking stocks of low BE/ME ratio the investor is taking risk and hence he can expect higher returns. The size effect and value effect can be translated into portfolio strategies by combining the small-large and value-growth stocks, preferably internationally diversified. For e.g., since we know that small stocks provide higher returns, we can make a portfolio where we take a long position on small stocks and take a long position on the large stocks while keeping equal weightage in the value and growth stocks. Also, since value stocks provide higher returns than growth stocks, we can have a portfolio with long positions in value stocks and short positions in growth stocks while keeping balanced weight in the small and large cap stocks. The risk adjusted performance can be given by = ((ER[a] - Rf)/STD[b]), where STD[b] is the standard deviation of the benchmark, R[a] is the return on portfolio a and RF is the risk free rate. Thus, using Exhibit 6 and...
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