Size Anomaly
Also written Size effect · Small firm effect
The finding that small firms, measured by total market value, have consistently earned larger risk-adjusted returns than large firms — contradicting market efficiency.
In plain language
If markets are efficient, a company's size should not, by itself, earn investors anything extra once risk is accounted for. Researchers found otherwise.
The workbook calls firm size a major efficient market anomaly. Many researchers examined the impact of size, measured by total market value, on risk-adjusted rates of return and concluded that small firms consistently experienced larger risk-adjusted returns than larger firms.
Such results stand in contradiction to the concept of market efficiency. In the workbook's words, the construction of small-cap portfolios is a direct outcome of the size anomaly.
How it works
Where it sits (Chapter 13, section 13.4). The workbook lists three anomalies: the January effect, the size anomaly and the value anomaly. Active portfolio managers use strategies built on such anomalies to try to earn alpha.
Why it is an anomaly. Size (market value) is public information. Under the semi-strong form of the EMH, trading on public information should not produce above-average risk-adjusted returns. A persistent small-firm premium after adjusting for risk is therefore inconsistent with efficiency.
How managers use it.
| Use | Workbook reference |
|---|---|
| Small-cap portfolios | Section 13.4.2 |
| Size as a factor in smart beta index rules (quality, value, volatility, size, momentum) | Chapter 18, section 18.5 |
| Size among the quality parameters of a fundamental factor model (RoE, RoA, RoCE, leverage, cash flow, size) | Chapter 18, section 18.6.2 |
Why anomalies may not last. Anomalies appear, disappear and reappear quite randomly; they are expected to disappear as others try to exploit them, though some persist for long periods (Chapter 14, section 14.5.1).
A worked example
Illustrative figures — not market data. A researcher sorts listed stocks by market value and tracks two equal-weighted portfolios over ten years, adjusting for risk using CAPM.
| Small-cap portfolio | Large-cap portfolio | |
|---|---|---|
| Average annual return | 17% | 12% |
| Beta | 1.2 | 1.0 |
| Risk-free rate | 6% | 6% |
| Market return | 12% | 12% |
| CAPM required return | 6 + 1.2 × (12 − 6) = 13.2% | 6 + 1.0 × 6 = 12.0% |
| Risk-adjusted excess (alpha) | 17 − 13.2 = 3.8% | 12 − 12 = 0.0% |
The small-cap portfolio earned more than its higher beta justified. On ₹10 lakh, that 3.8% is about ₹38,000 a year beyond what CAPM says the risk deserved. If that gap persists across many periods and samples, it is a size anomaly.
Note the logic: small-caps earning more raw return is not the anomaly. Their higher beta explains 1.2 percentage points of it. The anomaly is the 3.8% left over.
Why NISM asks about it
Chapter 13 (Concept of Informational Efficiency), section 13.4.2, describes the size anomaly as a major anomaly contradicting market efficiency and links it to small-cap portfolios. Chapter 14 (section 14.5.1) explains why anomalies may persist, and Chapter 18 (sections 18.5 and 18.6.2) shows size used as a factor. Questions test the definition — small firms earn larger risk-adjusted returns — and its conflict with the EMH.
Common exam traps
- Risk-adjusted, not raw. The anomaly is that small firms beat large firms after adjusting for risk.
- Size is measured by total market value in the workbook — not by sales or assets.
- Small beats large, not the other way round.
- Size ≠ value. The value anomaly is about book-to-price; the size anomaly is about market value.
- An anomaly contradicts the EMH; it does not prove markets are always inefficient. Anomalies can disappear once exploited.
Where this is taught
Free preparation for NISM Series XXI-BRelated terms
- CAPMA model that prices the return an investor should demand from a share: the risk-free rate plus beta times the market risk premium.
- Efficient Market HypothesisThe proposition that share prices already incorporate and reflect all relevant information — which, if true, leaves nothing for an analyst to find by studying that information.
- AlphaThe return a fund earned above what its beta and the benchmark say it should have earned — the slice of performance left over once the market has been given credit for its share.
- Market anomalyA pattern of returns that departs from what an asset's fundamentals and risk — as measured by CAPM or another pricing model — say it should earn, and so contradicts market efficiency.
- Semi-strong-form EfficiencyThe hypothesis that prices reflect all historical and publicly available information and adjust rapidly to news — so neither technical nor fundamental analysis earns above-average risk-adjusted returns.
- Value AnomalyThe finding that stocks with a high book value-to-price ratio have earned superior risk-adjusted returns — an anomaly against the EMH that underpins value investing.
- January effectA market anomaly in the US: year-end tax selling pushes prices down in late November and December, and the buying back in early January pushes them up — a pattern inconsistent with market efficiency.