Harvesting factor premiums in EM large-cap stocks

A long-standing debate is whether smaller-cap stocks tend to outperform their larger counterparts in the long run. One explanation for this phenomenon is that markets are more efficient when concerning larger-cap companies compared to their smaller-cap peers. Large-cap companies are also subject to extensive media attention and represented in passive and benchmark-aware portfolios. Additionally, their higher trading volumes, tighter bid-ask spreads, and lower transaction costs make them easier to trade with minimal price impact. As a result, it is assumed that new information is typically incorporated into their price more quickly, leaving fewer inefficiencies for investors to exploit.

However, Robeco's research¹suggests that there is a lack of strong evidence that supports a standalone size premium, while establishing that factor premiums tend to be stronger in small-cap stocks compared to their large-cap counterparts. Size, the authors reported, acts as a catalyst that amplifies the effectiveness of factors such as value and momentum. However, while small-cap stocks may exhibit stronger factor premiums, the key question remains: Can investors still capture meaningful factor returns within EM large-cap stocks?

To answer this, we analyzed the performance of small, mid, and large-cap stocks across all the factors in our integrated multi-factor stock selection model that has been live since 2004. Our findings confirm the established notion: factor premiums are generally lower for large-cap stocks compared to mid and small-cap stocks when using an approach that has a balanced combination of these factors. This profile remains consistent across individual factors, with one notable exception – quality. Given that high-quality firms tend to have stronger fundamentals and larger market capitalizations, this result aligns with expectations.

While this highlights the impressive returns of factors in the small-cap space, it’s important to note that these are theoretical, or "paper," returns that do not account for trading costs. In reality, incorporating transaction costs would significantly dampen these returns, as trading smaller-cap stocks tends to be far more expensive due to higher market impact and liquidity constraints.

All in all, our analysis highlights an important takeaway: despite lower factor premiums within EM large-cap stocks, they are still sizable and are less impacted by transaction costs. This is particularly the case when adopting an approach with a balanced combination of these factors, given the diversification benefits of blending multiple factors. More importantly, these findings are not confined to a theoretical framework – they translate into real, tangible outcomes for investors.

A direct comparison between the live track records of the Robeco Emerging Markets Active Equities strategy (which is based on the entire EM investment universe with an inception date of February 2008) and Robeco Emerging Markets 3D Active Equities strategy²(which focuses on approximately the 700 largest stocks in the EM investment universe with an inception date of January 2015) provides clear evidence of this.

While each strategy has consistently delivered strong excess returns across all time horizons, and as expected, the strategy based on the full investment universe has generated higher outperformance over time, what is particularly noteworthy is that the strategy focusing on the largest stocks has also delivered sizable and persistent outperformance.

This reinforces the notion that while the largest stocks may offer lower factor premiums, a systematic multi-factor approach remains highly effective in generating alpha – even in a more efficient market segment. For investors, this means they do not have to choose between a cost-effective approach and meaningful excess returns.

While our strategy based on the full investment universe has historically delivered higher excess returns, our strategy focusing on the largest stocks can offer investors the distinct benefit of a better liquidity profile resulting in lower transaction costs, a key consideration in EM given typically greater execution costs compared to DM. Indeed, our analysis found that a portfolio based on the full investment universe faces greater liquidity constraints. In contrast, a variant focusing on the largest stocks benefits from enhanced trade execution efficiency and a significantly higher capacity—roughly three times that of the portfolio based on the full investment universe—making it easier for investors to scale positions up or down with less market impact.

Our analysis also revealed that the estimated market impact costs were lower for the approach focusing on largest stocks while exhibiting a tighter weighted-average bid-ask spread. For investors, this translates into lower transaction costs. While the largest stocks may offer lower factor premiums, the liquidity advantage presents a compelling counterbalance, particularly for investors seeking cost-efficient exposure to EM.

Does a strategy focusing on the largest stocks lead to unintended sector or country allocation biases? Our analysis confirms that this is not the case, with sector and country compositions closely mirroring that of our strategy based on the full investment universe, ensuring that investors do not face unintended tilts when opting for a more liquid strategy.

Within the EM quant equities range, our Enhanced Indexing Equities strategy offers investors a smarter alternative to passive investing and is suitable as a core EM equity allocation. Meanwhile, our Active Equities strategy offers investors a smart way to generate alpha in a risk-controlled manner and can augment EM equity allocations with the aim of higher returns.

For clients seeking cost-efficient exposure to EM, we offer the EM Enhanced Indexing Equities Plus and EM Active Equities Plus strategies, both available as mandate and commingled vehicles. Additionally, we will launch the Robeco 3D Emerging Markets Equity ETF in March, providing an easily accessible vehicle for our EM Enhanced Indexing approach that uses our proprietary 3D portfolio optimization framework to balance risk, return, and sustainability considerations and focuses on the largest stocks in the universe.

The Plus range builds on our established Quant Equities EM strategies and focuses on approximately the 700 largest stocks in the investment universe. These strategies meet the needs of cost-conscious investors who want to access our Robeco Quant Equities alpha generation ability in EM but with lower fees.

Footnotes

¹Blitz, D, and Hanauer, M., 2021, “Settling the size matter”, Journal of Portfolio Management.
²The Robeco Emerging Markets 3D Active Equities strategy is formerly known as the Robeco Emerging Markets Sustainable Active Equities strategy.