Abstract
This paper investigates the role of the size factor for constructing investment portfolios and proposes a dynamic extension that accommodates the risk-free asset and time-varying weights. These weights are determined by a set of state variables given by the term structure of sovereign interest rates, variables describing market risk aversion such as the VIX index and the CRB Industrial return, and indexes reflecting investor sentiment towards the economic outlook. The empirical section explores the suitability of these state variables and analyses the out-of-sample performance of size factors idiosyncratic to the US, the UK and European financial markets that are compared against the dynamic version that optimizes the weights in each period. The results provide support to the different size factors except for periods of economic distress in which the optimal dynamic strategies are clearly superior.
Disclosure statement
No potential conflict of interest was reported by the authors.
Notes
1 It is important to notice that futures contracts on the large caps and small caps indexes considered in this paper are available for trading and allow the straightforward implementation of the investment strategies proposed in this paper.