Does Quality Matter?

Abstract: The purpose of this study is to investigate if there is any size effect in the Swedish stock market between April 2010 and December 2019, and if controlling for firms' quality improves the performance of a size-based investment strategy. The risk premium of firms with smaller market value of equity has since its discovery been under heavy scrutiny. Recent studies suggest that by quality-control, the size-based investment strategy can be improved. It is therefore highly relevant for the investor to understand how quality affects such a strategy. By employing a double sorting portfolio construction by size and quality as well as a cross-sectional regression using the Fama-MacBeth two-step regression, we examine if a small-minus-big portfolio yields a positive excess return and the interaction of quality and the size risk factor. We find that there is no size effect without any quality-control, in the Swedish stock market. However, in conjunction with the quality metrics, size is a relevant risk factor in asset pricing. In conclusion, by constructing the portfolio of high-quality firms, in terms of the Return on Assets or the credit rating of a Merton-based Credit Risk Model, the size-based investment strategy can be improved.