Were Fama and French Right about Value and Size? An Ex-Post Test
Fama and French’s 1992 seminal research, which identified the value and size factors, was met with skepticism. Even the authors questioned the underlying economic rationale for their findings. With a quarter century of data, let’s look back and see if the skepticism was justified. Have value and small-cap outperformed?
When I joined Buckingham Strategic Wealth more than 20 years ago it was an exciting time in the world of finance. The 1992 publication of Eugene Fama and Kenneth French’s paper, The Cross-Section of Expected Stock Returns, had changed the way both investors and advisors thought about the diversification of portfolios. Prior to then, we lived in a single-factor world, with market beta as the sole equity factor.
With the introduction of the Fama-French three-factor model, we moved into a multi-factor world – their world of “risk factors,” or securities that delivered above-market returns because investors demanded an ex-ante premium for accepting higher risks. And with that change, we went from focusing solely on diversifying the risk of market beta (which could be accomplished through owning just two funds, a total U.S. stock market fund and a total international stock fund, and then adding in the right amount of safe bonds) to a new focus on asset classes: large and small, value and growth.
While more complicated, this new world provided more opportunity to add value through portfolio design.
When implementing an investment plan to gain exposure to these new factors, we chose to use the structured portfolios of Dimensional Fund Advisors (DFA). We made that choice for a variety of reasons. While not index funds, which are designed to rigidly track their index, DFA’s funds are passively managed in the sense that there’s no individual stock selection or market timing. Each fund buys and holds all the stocks that meet the fund’s construction rules.
For example, a small-value fund might buy stocks in the bottom 25% of equities sorted by market capitalization and bottom 25% sorted by price-to-book value. To reduce trading costs, the fund might also employ a hold range of an additional 5% (meaning that once a security exceeded the 25% buy range it would no longer be eligible for purchases, although no sales would occur until the 30% hold range was exceeded).
The funds also try to minimize the negatives of indexing, such as forced trading when stocks enter or leave the benchmark index. Instead, they use block- and patient-trading strategies to minimize trading costs. In addition, the funds incorporate negative screens based on academic literature showing that stocks with certain characteristics have had poor returns. Thus, they exclude from their eligible buy lists very-low-priced (penny) stocks, stocks in bankruptcy, IPOs, small-growth stocks with low profitability and high investment, as well as certain other securities.
Another benefit of DFA funds is that they are designed to have deeper exposure to the size and value factors than is typical of most index funds. For example, both DFA and Vanguard run U.S. small-cap-value funds. The average market cap of Vanguard’s fund, VISVX, was about $3.2 billion at year-end 2016. In addition, its prospective P/E and P/CF were about 18.6 and 6.6, respectively. The comparable figures for DFA’s fund, DFSVX, were $1.4 billion, 16 and 4.8.
The DFA fund is much smaller (less than half the market cap) and more “valuey.” Thus, in addition to the benefit of not being a pure indexer, because of its deeper size and value exposures, the DFA fund also has higher expected returns.
DFA’s structured funds are more expensive than Vanguard’s index funds. For example, the admiral shares version of VISVX has an expense ratio of only 0.08%, while the expense ratio for DFSVX is 0.52%. And while costs are important, the real issue for investors is the cost per unit of risk/expected return.
To help explain the benefits of asset class investing and the use of well-structured passive asset class funds, such as those from DFA, I spent much of my first two years with Buckingham writing my first book, The Only Guide to a Winning Investment Strategy You’ll Ever Need.
The book was published in May 1998, and in it I explained the research and logic behind risk-based explanations for the size and value premiums (although today there is a great debate about the source of the value premium, and whether it’s risk, behavioral or some of both).