The common belief is that large-cap stocks don’t perform very well because they are already big and they don’t grow at high rates. However, is this true? What is the large-cap effect (factor) trading strategy?
In this article, we are going to see what the large-cap effect is, develop some trading and investment strategies, and backtest them.
What is the large-cap effect and anomaly?
The “large-cap effect” in stocks refers to the phenomenon where larger companies outperform smaller companies over certain periods or in specific market conditions.
This effect contrasts the well-known “small-cap effect (factor),” which suggests that smaller companies tend to outperform their larger counterparts over the long term. There are several reasons as to why this may happen:
- Market Leadership: Large-cap stocks often represent industry leaders and well-established companies that have a significant influence on their respective sectors and the broader market.
- Stability: Large-cap stocks are typically considered more stable and less volatile than smaller-cap stocks. This stability can attract conservative investors seeking safety and dividend income.
- Market Index Influence: Large-cap stocks often have a significant weight in major stock market indices like the S&P 500. Changes in the prices of large-cap stocks can have a disproportionate impact on these indices.
- Benchmark Performance: Many investment professionals and funds use large-cap indices as benchmarks for performance evaluation. As a result, the performance of large-cap stocks can drive investment decisions and portfolio management strategies.
- Diversification: Large caps are usually more diversified than small caps and are thus less prone to cyclical cycles. Some might have monopolies, like Google, for example.
- Dividend Payments: Large-cap stocks are more likely to pay dividends, making them appealing to income-focused investors.
- Defensive Qualities: In times of economic uncertainty or market downturns, large-cap stocks are sometimes considered more defensive because of their size, financial stability, diversification, and established market positions.
The theory sounds very compelling, but it’s time to test it. How do large-cap stocks perform?
Large cap effect trading strategy – backtest
In our backtest, we decided to go with the portfolios cooked up by French and Fama. But instead of just testing large-caps stocks as a whole, we mixed things up by throwing in some other factors.
Large-cap factor by value
So, the first portfolio is put together by looking at size and book-to-market (value). The book-to-market ratio for June of year t is the book equity versus market equity for the previous fiscal year ending in t-1. Here’s the scoop on how those three portfolios, sorted by size and value, performed over time:
Let’s examine the statistics and performance metrics of the strategy:
Large-cap effect and factor by quality
Now, let’s talk about the next batch of portfolios we’re testing:
These portfolios are a mix of size and quality. We’re looking at how profitable these companies are. Profitability for June in year t is determined by subtracting annual revenues from the combined total of the cost of goods sold, interest expense, and selling, general, and administrative expenses. This result is then divided by the book equity for the previous fiscal year, which concludes in t-1.
How did this factor perform? Here are the compounded returns (inside the chart it says erroneously “small” but it should be “large/big”):
Here’s a collection of statistical data concerning the strategy.
Lastly, we are going to backtest the portfolios based on size and investment. Investment is the change in total assets from the fiscal year ending in year t-2 to the fiscal year ending in t-1, divided by t-2 total assets. Here is the equity curve of this particular big-cap effect and anomaly:
Not bad, either. Here are some statistics about the strategy:
Large-cap effect trading strategy – conclusion
In summary, in this blog post, you’ve delved into the large-cap effect (factor) and anomaly in stocks, and we explored various trading strategies through backtesting. The results have shown the impressive performance of large-cap stocks, mainly when categorized by attributes like value, high quality, and low investment. A combination of any of these factors may yield even better results.