The historical data has shown that the value premium is smaller for large-cap securities than for small caps. But new research shows that large-cap investors can increase the premium by pursuing an equal-weighted strategy.
The academic value factor is a long/short portfolio formed by going long value (cheap) stocks and going short growth (expensive) stocks. The empirical research has found that the long/short value factor is generally stronger in smaller capitalization stocks. This should not be a surprise, as small stocks are riskier than large stocks. Over the period 1927-2021, the Fama-French U.S. large-value research index returned an annualized 12.0% versus 14.5% for the Fama-French U.S. small-value index. Over this period the U.S. total stock market (CRSP 1-10 index) returned 10.2%. However, when we confine our lookback to the last 40 years (1982-2021), the outperformance of large-value stocks almost disappears, with the Fama-French U.S. large value research index returning 12.4%, barely outperforming the CRSP 1-10 index return of 12.0%. Over the same period, the Fama-French U.S. small value research index returned 14.8%. In their 2015 paper, “Fact, Fiction, and Value Investing,” Cliff Asness, Andrea Frazzini, Ronen Israel and Tobias Moskowitz reached the conclusion that “by itself, value is surprisingly weak among large-cap stocks.” Such evidence has caused many to question the benefits of long-only value investing.
In his April 2022 paper, “Long-Only Value Investing: Does Size Matter?” Alpha Architect’s Jack Vogel took an interesting look into the value premium and the ability of the typical long-only investor to capture it. He examined long-only value portfolios to determine if size is a less important factor. He chose to compare equal-weighted (EW) large-cap value portfolios to small-cap value portfolios (without microcaps, as they have limited liquidity and can be expensive to trade). Vogel chose an equal-weighting scheme for large value to eliminate the potential influence of a handful of mega-large-cap stocks from driving the results associated with value-weighted (VW, or market-cap weighted) portfolios. By definition, an EW scheme will impart a small-cap tilt to the portfolio relative to a VW scheme.
Vogel’s data sample covered the period July 1973-December 2020 and included stocks traded on the NYSE, AMEX and Nasdaq. He identified the 1,000 largest firms (about 90% of the total market capitalization) as large-cap stocks and the smallest 2,000 firms as small-cap stocks. He divided portfolios into either terciles (three groups), quintiles (five groups) or deciles (10 groups) on each of the various value measures used – book-to-market (B/M), earnings-to-price (E/P), cash flow-to-price (CF/P), enterprise multiple (EBIT/TEV) and a composite of the four. For developed international markets (the countries included in the MSCI EAFE Index), data covered the period 1994-2020. All portfolios were formed on June 30 each year and held for 12 months. Following is a summary of his findings:
- EW large-cap value portfolios and small-cap value portfolios (both market-cap weighted and equal weighted) earned statistically similar returns – the average monthly return to large-cap EW (1.29%) was very close to the small-cap value portfolios' monthly return, either 1.36% (VW) or 1.39% (EW). That does not consider the higher trading costs of small-cap portfolios.
- While they earned similar returns, the EW large-cap value portfolio had vastly superior liquidity characteristics relative to the small-cap equivalent.
- Large-cap EW portfolios had a position-weighted market capitalization that was, on average, 19.27 times the EW small-cap value portfolio and 12.74 times the VW small-cap value portfolio.
- The average daily volume (ADV) of the large-cap portfolios was 18.72 times the ADV of the EW small-cap portfolios and 11.66 times that of the VW small-cap value portfolios.
- The results were robust to various value metrics, to subperiods, to including microcaps and to other tests.
- Factor regressions (versus the Carhart four-factor, Fama-French five- and six-factor (plus momentum), and Q-factor models) showed that large-cap EW value portfolios and small-cap value portfolios have statistically indistinguishable historical returns, even after accounting for additional factors.
- Using the composite value metric, the average discount of large-cap stocks relative to small stocks was 12% (e.g., a P/E of 10 versus a P/E of 8.8.). Thus, one should expect slightly stronger performance for small-cap value portfolios relative to large-cap value (EW) portfolios.
- International results were similar. For example, using the composite EW for large value produced a return of 92 basis points (bps) per month versus 99 bps per month for both EW and VW small value.
His findings led Vogel to conclude: “The critical implication of this research, and its importance to systematic value investors, is that smaller is not always better. In fact, given the significantly higher liquidity among equal-weighted large-cap value portfolios, the data suggests that value investors who prefer liquidity should prefer equal-weighted large-cap value portfolios. … If nothing else, the data suggests that practitioners should split their value allocations across the large-cap value (equal-weighted) and small-cap value since these portfolios have zero overlap but similar historical returns, highlighting a potential diversification benefit.” He added: “This paper is not saying that the academic value factor, a long/short portfolio, does not work better in small-cap stocks. In unreported results … the academic value factor, a long/short portfolio, is weak amongst large-cap stocks while showing better performance in small-cap stocks.”
EW versus VW
Regarding the choice of EW (instead of the traditional VW) for large stocks, Vogel did note that when using VW for large caps, he found a more significant premium: The average difference between large-cap value VW over the entire sample was 0.20% a month compared to small-cap value VW and 0.23% a month compared to small-cap value EW. In nine out of 30 instances, the performance difference was significant at the 5% level, while the performance difference was significant in 20 of the 30 instances at the 10% level. In other words, at least economically, size matters in large value stocks (just as it does across all value stocks)!
Just as economic theory would predict, over the period 1927-2021, the Fama-French U.S. large-value research index returned an annualized 12.0% versus an annualized return of 14.5% for the Fama-French U.S. small-value index (an outperformance of 2.5% percentage points per annum). Economic theory would also predict, as Vogel demonstrated, that the advantage shrinks if one uses equal weighting for large stocks – it yields a higher average monthly return than value weighting them, resulting in a smaller return spread against the small-cap value portfolio. The reason is simple: Equally weighting large value stocks creates a portfolio with more weight to smaller stocks within the large cap universe.
To get a sense of how much the size characteristics can be skewed by equally weighting, consider the holdings of Russell 1000 as of March 2022. The largest holding was Apple (AAPL), with the weight of 6.4%; the smallest was GoHealth (GOCO), with 0.0001 bps. Equally weighting the holdings of Russell 1000 would weight both of them at 10 bps, underweighting Apple by a factor of 65 and overweighting GoHealth by more than 700 times!
EW within large-cap value stocks is a backdoor to incorporating an emphasis on the size premium while also reducing concentration risk. Investors should expect the value premium within both large caps and small caps; thus, they can choose to pursue it within large caps, small caps or both. The benefit of pursuing it in both is that it increases the probability of capturing the premium. While some might doubt the ability of managers to capture the value premium within small caps due to their being, on average, less liquid and more expensive to trade, the track record of firms such as AQR, Avantis, Bridgeway and Dimensional shows that broad diversification, implementation expertise and a flexible daily trading process has delivered the value premium across market caps.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based upon third party data which may become outdated or otherwise superseded without notice. Third party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party websites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. The opinions expressed by featured authors are their own and may not accurately reflect those of the Buckingham Strategic Wealth®. Neither the Securities and Exchange (SEC) nor any other federal or state agency have approved, determined the accuracy, or confirmed the accuracy of this article. LSR-22-292
Read more articles by Larry Swedroe