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The following is excerpted from William Bernstein’s recently published book, Rational Expectations: Asset Allocation for Investing Adults (Investing for Adults), which is available from the link accompanying this article.
In Chapter 1, I discussed how small and value stocks had higher expected returns than the broad market, and later on we’ll see how aggressive periodic investing early in the life-cycle is much less risky than it looks. That doesn’t mean, however, that the lack of risk tolerance in younger investors won’t derail the majority of them.
The first question is whether tilting towards small and value stocks still carries a premium. The answer, I think, is yes; the premium for small stocks is a classic example of Ilmanen Risk: bad returns in bad times, which certainly showed up in the two great panics of the last century: the 1929–1932 and 2008–2009 bear markets. Ditto for value exposure, plus the behavioral attraction of investors towards growth stocks, also discussed in Chapter 1.
Some worry that now that large institutional funds – particularly hedge funds and ETFs – are chasing these factors, these premiums will erode, or completely disappear. This may now be true in normal times, but in bad states of the world, in the words of Billy Ray Valentine in Trading Places, the suckers get cleared out: not just naïve small investors but also hedge funds, who will be forced to unload their positions as their clients pull out and as their liquidity – that is, their sources of leverage – dries up faster than a rain gully in the desert. This will likely produce, as happened in 2008–2009, a sharp contraction in prices that will remind investors of the risk of the value and small premiums, and so set the stage for subsequent higher returns.
Theoretically, the young saver should tilt her portfolio heavily towards small value stocks. In Ages of the Investor I examined the process of dollar cost averaging, as a young saver might, into the S&P 500 and Fama-French small value series over a series of rolling 30-year periods. The value premium, for example, is quite fickle. Since 1926, it has yielded negative returns for as long as 15 years. The small premium is even worse, yielding negative returns for as long as 30 years.
This occasional long-lasting underperformance of both the small and value factors, though, is of more concern to lump-sum investments than to a stream of periodic investments, because the ability to occasionally purchase small and value stocks at a low price mitigates any temporary underperformance of small and value stocks.
In Ages of the Investor, I analyzed the tilt towards small and value with the following paradigm. I began with the inflation-adjusted return for the longest data series we have for small-value stocks – the Fama-French small-value index, with utilities included, between July 1926 and October 2011. This index returned 10.50% real-annualized, which was 3.88% per year more than the 6.62% real-annualized return for the S&P 500.
Now imagine that a real $100 per month (in 1926 dollars) was invested for 30 years – 360 monthly purchases – for all of the starting dates between July 1926 and November 1981. In each and every case, the small-value strategy beats investing in the S&P 500 – sometimes by a huge margin.
But the 3.88% annualized return advantage of small value stocks during this period is unrealistic, as already discussed. Figure 2-7 shows that when the returns of small value stocks and the S&P were equalized at 6.62% by adjusting the monthly returns down by a constant amount, the small value strategy still won 71% of the time, because the greater volatility of small stocks allowed for a greater number of shares to be bought at lower prices.
The reason, once again, is the paradoxical nature of the small-value strategy: higher volatility than a conventional 100% S&P 500 strategy and, thus, more opportunity to buy at much lower prices. The excess returns of both strategies, of course, come with a double cost. Small value stocks have much greater volatility and, thus, far greater emotional demands on the investor – in plain English, stomach-churning uncertainty. (Later on, we’ll discuss another strategy, that of leveraging stock exposure, that also sports the paradoxical phenomenon of higher returns through higher volatility early in the savings phase.)
Nonetheless, discipline has its rewards. Figure 2-8 plots what happens to the success rate of the small value strategy versus the S&P strategy as a function of the returns difference between the two asset classes; not until small value stocks underperform the S&P 500 by 0.64% is the 50% success point breached.
During the past decade, two additional "tilt factors" have emerged: momentum and profitability. First, momentum. It has long been known that shares with high past short-term returns tend to have higher short-term future returns; between January 1927 and March 2013, for example, a portfolio of high-momentum stocks has beaten a portfolio of low-momentum (that is, negative returning) stocks by 6.91% per year. Recently, strategies that harvest these returns have become quite popular in the hedge fund space. Figure 2-9 plots the 10-year annualized return of the momentum factor (MOM: high momentum stocks versus low momentum stocks).
Note, first of all, how MOM was strongly negative during the worst periods of economic crisis. In actuality, these two “momentum crashes” occurred just after the stock market rebounded in July 1932 and March 2009. Figures 2-10 and 2-11 demonstrate this curious relationship between the returns to the market, value, and momentum factors around the time of the market bottoms in mid-1932 and early 2009.
While many do not consider momentum to be a risk premium, these two plots suggest that it very well may be. What happens during a severe market downturn is that blue-chip, “high quality” companies, which are most often growth companies, suffer less damage. In the months leading up to a cataclysmic market bottom, these wind up being the high-momentum stocks. But when the market snaps back after the recovery, as happened after July 1932 and March 2009, the “junkier” low-momentum stocks with poor trailing one-year returns recover most strongly, producing a “momentum crash.” The key thing is that the overall return of momentum exposure during the bad times surrounding the market bottom is negative, a classic example of “bad returns in bad times,” and thus, in my opinion, qualifies as a risk factor. Paradoxically, it is an excellent short-term diversifier, since its returns during the period of worst returns – the first year in each plot – is positive.1
Finally, recent research demonstrates that firms that have high profitability, which we can functionally define as the earnings/book value ratio, tend to also earn a premium, in the range of several percent per year. This is surprising, since these tend to be growth companies.2
To sum up, we’ve identified four “tilt factors” that generate excess returns: small size, value, momentum, and profitability; the small premium is tiny, at most a percent or two, whereas the other three are in the range of several percent. At first blush, this all seems too good to be true: added up, the total “tilt premium” would seem to be in the vicinity of 15%–20%.
Not so fast. First, since all of these factors are long/short portfolios, the long-only investor gets just half of these. Next, the small value corner of the investment universe consists of, depending on the way the market is sorted on these two factors, at best several percent of total market cap. Add sorts for momentum and profitability, and you’re down to a poorly diversified fraction of a percent of the investable universe. In the real world, the best you can do is to try to find reasonably diversified portfolios consisting of a large, representative sample of the market that score reasonably high on a weighted scale of all the factors, which drastically cuts the overall expected benefit from grazing multiple premia – and that’s before factoring in the rapidly escalating amount of money chasing these strategies: As I’m writing this, mutual fund and ETF providers are already rolling out products that capture various combinations of these factors, but because of this multiple-factor size constraint, none will be able to load strongly on all of them; optimal strategies will likely involve relatively weak sorts on multiple factors and offer at best a few percent return premium over the broad market.
Moreover, financial economists will, in the future, identify yet more factors associated with excess returns, so this is a highly fluid area; you should stay tuned, and caution is advised.
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