Key Takeaways
- A cautious view on the First Trust Small Cap Growth AlphaDEX Fund (FYC) argues it is a small-cap, low-quality risk that may lag higher-quality funds while oil, inflation and interest rates stay elevated.
- The size premium small cap investors hope for is the idea that smaller companies earn higher long-run returns than larger ones, but the evidence is debated and may be tied to company quality rather than size alone.
- For the CFA exam, treat the size premium as a claim to test, not a fact to memorise: ask what risk it compensates, whether it survives after costs, and whether it is really a quality effect.
A Small-Cap Growth Fund Gets a Cautious Call
This week, the First Trust Small Cap Growth AlphaDEX Fund, ticker FYC, drew a sceptical assessment. The argument is that the fund is a small-cap, low-quality risk, and that it may lag higher-quality funds if oil prices, inflation and interest rates remain a problem. The same view points to softness in technology as another reason for caution. In short, the verdict is high risk with a questionable reward.
That is a useful story for a CFA candidate because it puts two ideas in one sentence: small and low quality. Many investors buy small-cap funds assuming that the extra risk will be paid back through higher returns over time. This call questions that assumption by describing the reward as questionable for the risk taken.
The call is a conditional argument: the combination of small size, lower quality and a tough macro setting may hurt. That kind of conditional reasoning is exactly what the exam rewards.
What the Size Premium Actually Claims
The size premium is the observed tendency for smaller companies to deliver higher average returns than larger ones over long periods. It became famous through multi-factor research that added a size factor to market risk when explaining stock returns. In that framework, small companies are not just a smaller version of large ones. They are treated as a separate source of return.
The usual explanation is risk. Small companies tend to have less diversified revenue, thinner financial resources and more fragile access to funding. They are often harder to trade, which means wider spreads and higher costs when you buy or sell. If investors demand compensation for those problems, the extra return is a fair reward for bearing them. This is why the size premium also shows up in practice when analysts estimate a cost of equity for a small private or listed business: they may add a premium on top of the basic market-based estimate.
A second explanation is behavioural or informational. Small companies receive less analyst attention, so prices may be wrong more often. That gives skilled stock pickers more room to find bargains. But the same lack of attention also means bad news can be hidden for longer, and a cheap stock can stay cheap. Less coverage cuts both ways.
Why the Premium May Not Exist
Here is where the headline fund matters. A premium that appears on paper is not guaranteed to appear in your account. Several problems get in the way.
The premium may be a quality effect
A well known line of research argues that the size effect weakens a lot once you account for quality. In plain terms, small companies as a group include many weak, unprofitable or heavily indebted firms, and these drag down the average. If you separate the strong small companies from the weak ones, the case for size alone becomes much thinner. That is the worry behind describing a fund as small-cap and low-quality at the same time. You may be buying the part of the small-cap universe that has the weakest claim to a premium.
The premium may not survive real-world frictions
Paper returns ignore trading costs, and small stocks cost more to trade. Funds that hold them also face the problem that the most attractive names are the least liquid. An index or a rules-based fund must buy what its method selects, not what is easy to trade. Costs reduce the return you actually keep, and the premium is often modest compared with the volatility you take on.
The premium is not steady
Even if a long-run premium exists, it can vanish for many years. A strategy that pays off over decades can still lag badly over a typical holding period. Higher borrowing costs and persistent inflation tend to hurt companies with weaker balance sheets first, which is the macro concern raised about FYC.
What This Means for Your CFA Preparation
For Level 1 equity, the lesson is not to decide whether the size premium is true. It is to think clearly about what each claim assumes. When a question mentions small companies, ask yourself four things. What risk is the extra return supposed to compensate? Is the evidence about averages or about a particular fund? Could another factor, such as quality or liquidity, explain the result? And do costs and market conditions change the picture?
This habit also protects you from a common exam trap: treating a historical average as a forecast. Whether an observed premium continues depends on whether the underlying risks are still being rewarded. The FYC call is one example of asking whether the reward is worth the risk.
The full mechanics, including how factors are defined, how size enters return and cost of capital models, and how to answer the tricky wording in exam questions, are taught step by step in the EduFite course. If you want to find out whether you can already separate a genuine risk premium from a story about one, try a free 30 question mini mock exam and see which equity topics need more work before test day.
FAQ
What is the size premium in simple terms?
It is the idea that smaller companies have earned higher average returns than larger ones over long periods, as compensation for extra risks such as weaker finances and lower liquidity.
Is the size premium small cap investors expect guaranteed?
No. It is an historical average that can disappear for long stretches, may be reduced by trading costs, and may be explained partly by company quality rather than size alone.
Why does quality matter when judging small-cap funds?
Small-cap universes include many weak, unprofitable or indebted firms. If a fund holds a lot of them, it may carry the risk of small caps without much of the reward, especially when inflation and interest rates are high.
How should CFA Level 1 candidates treat the size premium?
Treat it as a claim to evaluate. Ask what risk it rewards, whether other factors explain it, and whether costs and market conditions change the outcome.