Size effect has been extensively documented for most of the world capital markets including India. This paper deals with the causes of the size effect in the Indian stock market. The authors test whether the operating financial and liquidity characteristics substantially differentiates small firms from the large ones. It is also verified here whether small firms are inherently riskier than the large ones, as implied by the risk story argument. It is found that there is a statistically significant difference between the small and large firms with regard to operating efficiency, financial leverage, stock liquidity, institutional neglect and distress level. The empirical results highlight the overlapping of size and value (BE/ME) effects, unlike in the US market, where they are found to be independent risk factors. The support for the risk story provides an argument in favor of multifactor benchmarks as compared to the Capital Asset Pricing Model (CAPM), which fails to explain fully the cross-sectional variations in the average returns of size-sorted portfolios. The findings have implications on mutual fund managers and other investment strategists since a major part of the size premium which they perceive as an opportunity for arbitrage could actually be a compensation for unaccounted risk.

Size effect is one of the most prominent asset pricing anomalies. In simple terms it implies that small firms’ stocks tend to outperform large firms stocks over a long period of time. Discovered by Banz (1981) in US stock market, size effect has been found to be a universal phenomenon1. Studies have also shown the presence of a strong size effect in Indian stock market2. However, there is a controversy regarding the possible causes of size effect. There are different explanations of the documented size effect. One viewpoint is that small firms are inherently riskier than large firms owing to differences in their operating, financial and liquidity risk characteristics. It has been empirically shown that small firms’ stocks are less liquid and more neglected by institutional investors and security analysts (Amihud and Mendelson: 1986, James and Edmister: 1983, Arbel and Strebel: 1982, Arbel, Carvell and Strebel: 1983). Small firms are exposed to higher operating and financial risks (Chan, Chen and Hseih: 1985). Chan and Chen (1991) suggest that the small firms examined in the empirical literature tend to be marginal firms. They have lost market value because of poor performance. They are inefficient producers, and are likely to have high financial leverage and cash flow problems. Small firms tend to have poor customer base, outdated technology, less diversified product lines and relatively lower access to financial market.

Keeping in view the above-mentioned characteristics, the prices of small firms’ stocks tend to be more sensitive to changes in the economy as they are less likely to survive adverse economic conditions. In a competitive economy with continuing technological changes, firms that become relatively inefficient or have higher costs will decrease in relative size (as measured by market capitalization or any other non-market-based measure). While a more efficiently run firm may do well and even prosper if the aggregate economy is growing slowly, a less efficiently run firm may not survive a low growth rate for long. However, size as anomaly to the standard CAPM might have arisen due to the reason that beta is not capturing full systematic risk of small firms. This implies that beta is not a comprehensive risk measure. Alternatively, if we believe that CAPM is a rational benchmark, then size effect is owing to irrational investor behavior.

Applied Finance Journal, Indian Stock Market, Capital Markets, Capital Asset Pricing Model, Financial Risks, Liquidity Risk, Financial Market, Market Capitalization, Centre for Monitoring Indian Economy, CMIE, Market Equity Ratio, Debt Equity Ratio, Mutual Funds.