Question

The value (or book-to-market) effect and size (or small cap) effect are frequently called market anomalies. Explain why.

Answer 1

ANSWER:-

Following explanation shows why Value effect and Size effect are called market anomalies:-

Size effect anomaly:-

There are some anomalies that shake the assumption of efficient market. One of the most studied is related to the size of the companies. Some authors have demonstrated that smaller companies (that is, the ones with smaller market capitalization) tend to outperform larger firms.
In reality it’s very easy. A company’s economic growth is bound to its stocks performance, and the smaller firms grow more easily than the larger companies, and that is reflected on their stocks.

However, smaller companies’ good behaviour is not systematic over the years. Furthermore, smaller companies had a better behavior than larger firms after deep market crisis.

The lower the market capitalization, the higher the volatility. Those portfolios comprised of small-caps will be more volatile than others.

Value effect anomaly:-

The value effect is the tendency of value stocks to outperform the market in the long term. A number of explanations have been suggested for the value effect. It is a compensation for risk. It is a genuine effect.

There is an evidence that the strength of the value effect varies from sector to sector, being strongest in value sectors and weakest in growth sectors. In addition, there is a sector value effect, even though this is weaker than the company level value effect.
It has also been claimed that the value effect applies at a country level, so investing in fast growing countries with high market PEs (i.e. emerging markers) will under-perform investing in markets with low market PEs.