Readers of this publication are well versed in the findings of the 1992 Fama-French paper, which documented the outperformance of small-capitalization and value stocks. But few are aware of these two sentences, which appeared in the conclusion of that paper: “Even if our results are consistent with asset-pricing theory, they are not economically satisfying. What is the economic explanation for the roles of size and book-to-market equity in average returns?”
Fama and French’s self-professed uncertainty over why small-cap and value stocks have outperformed the market is particularly interesting in light of Larry Swedroe and Kevin Grogan’s new book, Reducing the Risk of Black Swans: Using the Science of Investing to Capture Returns with Less Volatility, which explains, among other things, the benefits of overweighting those stocks.
Swedroe is director of research for the BAM Alliance, a community of more than 130 independent registered investment advisors. Grogan is director of investment analysis for that firm.
Swedroe and Grogan provide an excellent overview of modern portfolio theory, including the development of the capital asset pricing model, the Fama-French (F-F) paper and newer research, such as the identification of additional factors (e.g., momentum and profitability) that claim to explain elements of risk not explained in the original F-F model.
They demonstrate that the level of market valuation is highly predictive of future returns, based on the Shiller cyclically adjusted price-to-earnings (CAPE) ratio. Swedroe and Grogan then show how to build a “more efficient” portfolio “scientifically” by using funds that overweight small-cap and value stocks. Using historical data, they show that such portfolios provided higher risk-adjusted returns than does did a 60/40 stock/bond portfolio. Using small-cap and value stocks, as the authors demonstrate, one needed a lower equity allocation to achieve the same results as a traditional 60/40 portfolio.
The book also discusses Swedroe’s “Larry portfolio,” a term coined by New York Times columnist Ron Lieber in a 2011 article. Exactly how this portfolio is constructed is not clear from the text, but it contains a 28% allocation to U.S. small-value stocks, developed-markets small-value stocks and emerging-market value stocks. The remaining 72% is in five-year Treasury bonds. The Larry portfolio beat a 60/40 portfolio on a risk-adjusted basis using historical data, despite its significantly lower equity allocation.
Swedroe and Grogan argue that the Larry portfolio is diversified, but not in the traditional sense. They claim that its diversification comes from its allocation to complementary portfolio “factors” (small-cap and value stocks), which have low correlations to one another while each producing positive returns.
The authors also argue for globally diversified portfolios, with allocations to markets with the highest expected returns (lowest CAPE ratios).
I have one issue with what is an otherwise strong technical discussion. The authors do not address the risk of inflation in the context of the portfolios they recommend. Their bond allocations use exclusively nominal bonds and they provide no guidance as to how they expect equity allocations to perform in an inflationary environment.
I suspect that most of the material in this book will be familiar to advisors, although there are a number of detailed points that will be new to some, such as how the expense ratio of a fund should be considered alongside its securities-lending revenue. Those who read Swedroe’s posts on sites such as Seeking Alpha will also be familiar with the material in this book. This book will be very useful to sophisticated clients – those who are comfortable with basic math and probability – and especially for clients of advisors who use portfolios that overweight small-cap and value stocks.
A test for fiduciaries
Let’s now return to the question Fama and French posed in their 1992 paper. Their question is one of many that fiduciaries must ask before adopting a strategy that overweights small-cap and value stocks or that relies on risk factors that have been culled from a regression analysis.
Here are four such questions, some of which are related to one another:
Is there an economic reason why these stocks have performed well historically?
This is the question Fama and French sought to answer in 1992, yet it remains unanswered today. Regression analyses, such as those used by Fama and French, cannot prove causality. Causality can be established only if there is an underlying economic reason for the correlation. Without causality, there is no reason to expect the correlation to continue in the future.
Indeed, the supposed outperformance of small-cap stocks has been disproven. Those stocks do not offer any risk-adjusted advantage over the market portfolio. In an email exchange, Swedroe acknowledged this point (although he maintained that small-cap stocks still have diversification value in a portfolio that also owns value stocks).
The source of the value premium remains a mystery. Some contend that value stocks are riskier because, for example, they typically have more debt and therefore command higher returns. A behavioral explanation has also been proposed: Investors prefer growth stocks and (irrationally) under-price value stocks.
Has the premium dissipated over time?
If a risk-adjusted premium has decreased over time, one must be concerned that too many investors are trying to exploit it and it will continue to dissipate. This is only an issue for the value premium, since there is no small-cap premium on a risk-adjusted basis.
The publicly available F-F factors provide the monthly difference between the returns on a combination of value stocks and the returns on a combination of growth stocks. In other words, it is an index that's long value stocks and short growth stocks. This difference could be considered the value-to-growth stock premium (not risk-adjusted). This difference compounds and annualizes to 4.57% over the period from July 1926 (when the F-F data start) through June 1992 (when the F-F paper was published), but it is only 2.78% from July 1992 through April 2014 (when the F-F data currently end).
So the value-to-growth stock premium fell by almost 40% after the F-F paper was published.
Are there reasons to expect the premium to dissipate in the future?
In a recent talk, Stanford professor and Nobel economist Bill Sharpe challenged advocates of smart-beta strategies, including overweighting small-cap and value stocks, to respond to two questions. Can the strategy be adopted by all market participants, or does it have a practical limit in terms of assets that can be invested? If it has a practical limit, then one should expect the premium to decrease over time.
For small-cap stocks, for example, it is obvious that the answer is "no" – eventually the dollars pursuing those stocks would make them mid- or large-cap stocks. The same is true for value stocks; the money pursuing them will eventually drive prices up and erase their risk premium.
In an email exchange, Swedroe essentially agreed. He said that smart-beta strategies "can be right for everyone, but everyone cannot pursue them. Eventually, prices would move and premia would shrink."
Does the persistence of the premium rely on a large group of investors behaving “stupidly”?
Sharpe's other challenge was that smart-beta proponents assume that, if they are "smart" to invest in securities such as small-cap and value stocks, then there must dumb investors who hold the market portfolio and others who are "really dumb" and underweight those securities. Therefore, according to Sharpe, smart-beta strategies rely on exploiting the stupidity of others.
In response to this challenge, Swedroe asserted, "There are really dumb investors, such as those who pursue lottery-type stocks." (Lottery stocks are those that have a small probability of a large payoff but have a low expected return.) Swedroe said he provided further justification for smart-beta strategies in this post on ETF.com.
Conclusion
My point is not to disparage value- and small-cap-oriented strategies. Funds such as those offered by Dimensional Fund Advisors (DFA), which rely heavily on those strategies, have been among the best performing over the last several decades. Instead, I raise these questions because no fiduciary should rely on past performance as an indicator of future returns.
Be sure you can answer these questions before you undertake the recommendations advocated by Swedroe and Grogan.
I’ll let the authors provide a final warning. “Just as the equity premium is compensation for taking risk, so are the size and value premiums,” they wrote. “Thus, we add the usual ‘disclaimer’ that the future may look different from the past. There are no guarantees in investing.”
Read more articles by Robert Huebscher