Cross-Sectional Anomalies—Size and Value Effects

A trader wants to employ the size effect anomaly to earn abnormal profits. If the trader expects stock prices will rise in the near future, which of the following strategies is the trader _most likely_ to employ?

Incorrect. In a rising market, such a portfolio will underperform the market if the size effect is true.

Incorrect. The market capitalization of the firm is the "size" referred to in the size effect, not the P/E ratio. This might be a good strategy for a value investor.

Exactly! The size effect is the consistent outperformance of small capitalization stocks over large capitalization stocks, on a risk-adjusted basis. This strategy will generate abnormal returns if the size effect holds.

Buy large company stocks and short small company stocks

Buy small company stocks and short large company stocks

Buy stocks with small P/E ratios and short stocks with large P/E ratios