Sources of Size Effect: Evidence from Indian Stock Market

Abstract

Size effect has been extensively documented for most of the world capital markets including India. In this paper we examine the causes of the size effect in Indian stock market. We test whether operating, financial and liquidity characteristics substantially differentiate small firms from large firms. We also verify whether small firms are inherently riskier than large firms as implied by the risk story argument. We find statistically significant difference between small and large firms with regard to operating efficiency, financial leverage, stock liquidity, institutional neglect and distress level. The empirical results also highlight the overlapping of size and value (BE/ME) effects unlike in US market where they are found to be independent risk factors. The support for risk story provides an argument in favor of multi-factor benchmarks as compared to CAPM which fails to explain fully the cross sectional variations in average returns of size sorted portfolios as shown by previous empirical work. The findings have implications for mutual funds managers and other investment strategists as a major part of the size premium, which they perceive as arbitrage opportunity, could actually be a compensation for unaccounted risk.

Keywords: Size Effect, Size premium, Capital Asset Pricing Model, Operating profitability, Financial risk, Liquidity risk

JEL Classification: G12,G14