Association of value and size factors with equity systematic risk : research on S&P 500 from 2013 to 2018

Abstract

The purpose of this thesis is to investigate the relation of value and size factor anomalies to the systematic risk of equities. Value and size effects are academically proven market anomalies that have existed on various markets and time periods. Value anomaly refers to the tendency of stocks trading at low price multiples, such as the price to book value of equity (P/B), to outperform stocks trading at higher price multiples. Size anomaly means the tendency of smaller market capitalization stocks to outperform larger market capitalization stocks. For example, Fama & French (1996) and Malkiel (2014) argue that these market anomalies rise from these investment types being exposed to larger than average risk, which would explain the abnormal returns. Because of this proposition, these anomalies are also called risk factors. Investment styles exploiting these anomalies are called factor investment strategies or “Smart Beta” strategies as branded by the investment industry.

Factor investment strategies have become increasingly popular during recent years and there is a wide range of easily available investment vehicles such as ETF:s to employ these strategies. The goal of our research is to investigate if the value and size factor strategies carry with them a higher systematic risk than that of the market. This is done by making a set of regression analyses on the constituent stocks of the Standard & Poor’s 500-index. In the regressions we test for associations between beta and firm size and value factor proxies price-to-book, price-to-earnings, and dividend yield. Value factor proxies are investigated in separate regressions to avoid multicollinearity. The dataset is then further divided into industry sectors and separate regressions are made for each sector to explore for sector differences. The linkage of size effect into large cap S&P 500 stocks can be criticized but we find it relevant to investigate also this factor since the range of company sizes across S&P 500 is by any standards high, with 60-month average market capitalizations ranging from 3 billion USD to 642 billion USD. We aim to answer the question if and how loading an investment portfolio with value or size factor tilts influences the level of systematic risk the portfolio is exposed to.

Our empirical analysis finds that overall the factor proxies do not have an association to either increasing nor decreasing systematic risk. Price-to-earnings ratio, price-to-book ratio, and market capitalization do not have statistically or practically significant relation to beta. Dividend yield has a statistically and practically significant negative association with beta across S&P 500. However, this effect is not observed within separate sector regressions, indicating that the effect across S&P 500 might be caused by sector differences. In short, value and size factor investment strategies do not influence the level of systematic risk of a portfolio except if value factor is proxied by dividend yield, in which case it has a beta decreasing effect.