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).
Have value and small-cap lived up to their promises?
As the calendar turned into 2017, I thought it would be a good idea to see, ex-post, how the strategy of “tilting” portfolios to the size and value factors (by holding more small and value stocks than either a total market fund, or similar Vanguard index funds, own) had performed. In other words, this serves as an out-of-sample test to see if, after including the real-world costs of fund expenses and trading, investors were rewarded with higher returns by tilting the portfolios to the size and value factors. Or, would investors have been better off owning lower-cost, total market funds?
Because the book was published in May 1998, I’ll review the returns for DFA’s funds from June 1998 through year-end 2016, and compare them to the performance of the U.S. total market, the MSCI EAFE Index (representing the non-U.S. developed markets) and the MSCI Emerging Markets Index.
The DFA funds represent those available over the time period, excluding any strategies that are market-index oriented, and the Vanguard funds were selected based upon similar asset-class exposure or for general market-index representation. For funds that share similar strategies or have multiple share classes, I show the lowest-cost versions that are available over the entire time period. (Again, in the interest of full disclosure, my firm, Buckingham, recommends DFA funds in constructing client portfolios.) Keep in mind that indices don’t have any costs while even pure index funds have expense ratios and trading costs.
DFA funds can be purchased through some 529 and 401(k) plans, but generally they are available only through an advisor. An investor would incur fees from that advisor; those fees can vary greatly (in some cases they are very low) and may cover the full range of financial planning services provided by the advisors. Vanguard funds can be purchased directly by investors.
Annualized Returns: June 1998-December 2016[1]
Fund
|
Annualized Return (%)
|
Volatility (%)
|
Sharpe Ratio
|
U.S. Equities (CRSP 1-10 Index)
|
6.4
|
18.7
|
0.30
|
Vanguard Total Stock Market Index (VITSX)
|
6.4
|
18.5
|
0.31
|
Vanguard Value Index (VIVAX)
|
6.1
|
17.4
|
0.33
|
DFA U.S. Large Value III (DFUVX)
|
7.8
|
19.1
|
0.42
|
Vanguard Small Cap Index (VSCIX)
|
8.4
|
20.5
|
0.44
|
DFA U.S. Small (DFSTX)
|
9.3
|
21.7
|
0.48
|
DFA U.S. Micro Cap (DFSCX)
|
9.7
|
22.9
|
0.49
|
Vanguard Small Cap Value Index (VISVX)
|
8.9
|
16.5
|
0.51
|
DFA U.S. Small Value (DFSVX)
|
10.1
|
22.9
|
0.51
|
|
|
|
|
Non-U.S. Developed Equities (MSCI EAFE Index)
|
3.6
|
21.5
|
0.18
|
DFA International Value III (DFVIX)
|
5.6
|
23.3
|
0.29
|
DFA International Small (DFISX)
|
8.1
|
23.6
|
0.41
|
DFA International Small Value (DISVX)
|
9.3
|
24.2
|
0.45
|
|
|
|
|
Non-U.S. Emerging Equities (MSCI Emerging Markets Index)
|
7.4
|
34.2
|
0.36
|
Vanguard Emerging Markets Stock Index (VEIEX)
|
7.4
|
33.3
|
0.35
|
DFA Emerging Markets (DFEMX)
|
8.1
|
33.7
|
0.36
|
DFA Emerging Markets Value (DFEVX)
|
10.8
|
40.6
|
0.40
|
DFA Emerging Markets Small (DEMSX)
|
11.1
|
39.8
|
0.42
|
Investors were well rewarded in the form of higher returns for their belief that small and value stocks were likely, but not certain, to achieve higher returns. In fact, in each case, whether using DFA’s structured funds or Vanguard’s index funds, investors in small and value funds were rewarded not only with higher returns, but also with higher Sharpe ratios than total-market funds or the index itself provided.
Domestically, where there are comparable Vanguard index funds for the small, large-value and small-value asset classes, the DFA funds, with their greater exposure to the two factors, provided both higher returns and higher risk-adjusted returns (despite higher expenses) during this period. This is a good example of the logic that “while costs matter, it’s the value added that matters more.”
In other words, the cheapest funds are not necessarily the most efficient.
Because financial innovation didn’t end with the publication of the aforementioned paper from Fama and French, in our new book, Your Complete Guide to Factor-Based Investing, my co-author, Andrew Berkin, director of research at Bridgeway Capital Management, and I bring investors up to date on the advances in research.
While the academic literature now contains more than 600 factors, a number so great that John Cochrane called it a “zoo” of factors, the good news is that, within the factor zoo, Andy and I believe you need only a small number of them to explain almost all of the differences in returns between diversified portfolios. The book establishes the criteria required to consider a factor for investment. To be considered, a factor must provide incremental explanatory power to portfolio returns[2], have delivered a premium return, and should also meet all of the following criteria. It must be:
- Persistent – across long periods of time and different economic regimes.
- Pervasive – across countries, regions, sectors and even asset classes.
- Robust – to various definitions. For example, there is a value premium whether it is measured by price-to-book, earnings, cash flow or sales.
- Investable – after considering trading and other costs.
- Intuitive – based on risk- or behavioral-driven explanations for the premium, providing the rationale for believing that it should continue to exist.
There are just a small number of factors that meet these criteria. The book provides you with the research and the historical evidence on each of the factors we cover so that you can make an informed decision on whether or not to include exposure to it.
There’s further good news. Today’s investors have far more choices and better-designed funds than were available to them at the time I wrote The Only Guide to a Winning Investment Strategy You’ll Ever Need. There are mutual funds and ETFs that allow investors to access any of the factors to which they want exposure. Goldman Sachs offers a multi-factor ETF and Vanguard has small-cap and value funds, each with expense ratios of approximately 10 basis points. The strong competition for assets has driven expense ratios ever lower, to the point that in some cases they are approaching zero.
Larry Swedroe is director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.
[1] Returns calculated from June 1998 through December 2016 and annualized. Volatility and Sharpe ratio calculated based upon annual data from January 1999 through December 2016. Data is from DFA Returns 2.0 and Lipper. Information shown to reflect the potential benefits to a portfolio of greater exposure to small and value stocks and this information should not be interpreted as a guarantee of future performance. These are not specific investment recommendations and are included for informational purposes only. It should not be assumed that any of the securities listed will prove to be profitable. Indices are not available for direct investment and their performance does not reflect the expenses associated with the management of an actual portfolio, nor do indices represent results of actual trading.
[2] The capital-asset pricing model (CAPM) was able to explain about two thirds of the differences in returns of diversified portfolios. Adding small and value (besides having premiums) raised that explanatory power to approximately 90%, which means they are clearly unique factors. Adding momentum moved that a bit further to the mid-90%s. Adding profitability helped a bit more, but obviously the incremental value is getting smaller and smaller as there is not much left to explain. I discussed that in Appendix G of Your Complete Guide to Factor Based Investing. If a factor doesn't add further explanatory power, it may be a factor but its explanatory power is subsumed by other factors (meaning other, well-known factors already explain returns without adding another one; they are not really unique).
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