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Jesse posted a article in Trading BlogThis is generally viewed as rational compensation for risk as investors must be enticed with higher expected returns in order to buy smaller companies that are often times in distress. In other words, it’s not a “free lunch,” although there are also behavioral arguments suggesting investors become overly pessimistic about the prospects for value companies and overly optimistic about the prospects for growth companies. When value stocks exceed expectations, and/or growth stocks fail to meet expectations, the value premium emerges. We can observe these relationships in the historical data by reviewing Fama/French and Dimensional Indices. Since 1930, there has been a 4.76% difference in annualized returns. This relationship has also been highly persistent over intermediate and longer-term timeframes. The following chart shows how often the small value index has had higher returns than the large growth index over rolling time periods. So far, we’ve only looked at US indices, so to give us additional confidence we can also look to historical data in International stock indices with data beginning in 1981. We see an even larger difference in relative returns with the International index data. This reduces the risk that the spread in returns is random chance in the historical data, along with how the effect has persisted after it was first published by Fama and French in the early 1990’s. The bar chart with rolling outperformance frequencies showed us that lage growth stocks have outperformed small value stocks about a third of the time over 3-year periods. We find this to be the case since 2017, and by an abnormally wide margin. What you see is not a typo. Since 2017, large growth stocks have beat small value stocks by 26.41% per year. This is the widest margin ever over this timeframe. This massive performance gap has created the largest spreads in valuations in history by many measures, even surpassing the late 90’s technology bubble. Conclusion Academic theory and long-term historical data highlights how small value stocks have higher expected returns than large growth stocks. These relationships don’t always materialize over shorter periods of time, such as 3 years, otherwise there would be no risk. Readers who strongly believe in the equity premium should also consider that stocks have underperformed risk-free Treasury Bills more than 20% of the time over 3-year periods, and about 13% of the time over 10 years. Again, risk and return are related and discipline is required. Since 2017 small value stocks have dramatically underperformed, testing investor discipline, while at the same time creating future opportunity. Spreads in valuation between large growth stocks are at records relative to small value stocks. Since valuations are one of the most reliable indicators of future performance that we have, it may be more likely than usual that small value stocks outperform large growth stocks. When uncertainty is elevated, such as today due to economic pressures from the global pandemic, investors may demand an even larger expected risk premium for small value stocks that are out of favor compared to big glamorous growth companies that are fun to brag to your friends about owning. So, what should you do? If you currently have little or no exposure to this category of the market, now may be a good time to consider adding it to your portfolio. If you already have greater than market cap weighted exposure like I do, it’s probably a good time to check your portfolio because the spread in recent performance may require you to rebalance back to your target allocation. This would involve trimming large growth exposure and using the proceeds to add to small value. Of course, it’s impossible to predict when things will change, many smart people have been calling for the relative performance bottom in small value stocks for months now, and for this reason you should only consider changing your portfolio if you see the “value” in small value and you’re willing to stick with it for the long run. Jesse Blom is a licensed investment advisor and Vice President of Lorintine Capital, LP. He provides investment advice to clients all over the United States and around the world. Jesse has been in financial services since 2008 and is a CERTIFIED FINANCIAL PLANNER™ professional. Working with a CFP® professional represents the highest standard of financial planning advice. Jesse has a Bachelor of Science in Finance from Oral Roberts University. Related articles Understanding Growth Vs. Value Stocks History is a Great Teacher The Best Chart I’ve Seen in 2020 Realistic Expectations: Using History as A Guide The Value of Equity Asset Class Diversification Total Stock Market Index Funds: A Diversification Illusion?
But first, a few definitions: “SCB”: Small Cap Blend. This represents an index of US small cap stocks “SCV”: Small Cap Value. This represents an index of US small cap value stocks “LCV”: Large Cap Value. This represents an index of US large cap value stocks “4-Fund Combo”: Equal weight S&P 500, LCV, SCB, and SCV Academic theory suggests that markets are highly efficient at pricing asset classes so that risk and reward are related. When an asset class has more risk, it should also have a higher expected return. Otherwise why take the risk? Specifically, from lowest risk/reward to highest: 1-month T-bills (cash)…lowest risk, lowest expected return Long term government bonds Large cap stocks (S&P 500) Large cap value stocks Small cap stocks Small cap value stocks…highest risk, highest expected return We see that the historical data matches the theory over the entire period. But certainly not over every 15-year period, which should be expected…otherwise there wouldn’t be risk if we knew with certainty that holding for 15 years would automatically produce a relative outcome of one asset classes versus another. Therefore, there is no period long enough where we can be certain of any outcome in markets. And for this reason, every investor must consider their own personal ability, willingness, and need to take risk. This is true not only for how much a portfolio should be in stocks vs. bonds, but also how much of that equity allocation should consist of small cap and value stocks. The right portfolio is the one that has the highest probability of meeting your long-term return objectives(one that is well diversified) and is also one that you can stick with. The diversification of the 4-fund combo never gives you the best outcome, which is a price to pay for also avoiding the worst outcome that you’re more likely concerned about. The period of 1960-1974 stands out, a period of 15 years where the popular S&P 500 index underperformed totally riskless 1-month T-bills (along with SCB & LT Gov Bonds). The 4-fund combo, due to the performance of value stocks, still produced a risk premium over T-bills. Over the long-term, which is the only period an equity investor should care about, diversification can reduce worst case scenarios. Yet it’s interesting that when I review the portfolios of new clients and prospects, it’s extremely rare to find any allocation at all to small cap value stocks. Whether that portfolio was built with the help of an advisor or not hasn’t seemed to matter, indicating that lack of awareness of the historical data is the likely explanation. I’ve written extensively in other articles about the higher expected returns of small and value stocks, as this has been known for at least 30 years. The last point I’ll make is that the same chart created with shorter periods, such as 1/5/10 year periods, has much more random outcomes. Again, this would be expected, and it’s why increasing your awareness of the range of potential outcomes over various time periods is one of the best things you can do to have proper expectations. My recent articles on market volatility digs deeper into this topic. Conclusion We should all attempt to judge the quality of every decision we make in our lives not solely based upon the after the fact outcome but based on the information we had available at the time of making the decision. With investments, this is especially true as we can only have historical data and academic theory to guide us. The science of investing is not like other forms of science where laws exist creating certainty of cause and effect outcomes. This means we should focus our attention on the things we can control such as diversification, asset allocation, and rebalancing. Once we’ve built our portfolios according to these principles, we can relax knowing that we’ve maximized our probability of having a successful investment experience. Jesse Blom is a licensed investment advisor and Vice President of Lorintine Capital, LP. He provides investment advice to clients all over the United States and around the world. Jesse has been in financial services since 2008 and is a CERTIFIED FINANCIAL PLANNER™ professional. Working with a CFP® professional represents the highest standard of financial planning advice. Jesse has a Bachelor of Science in Finance from Oral Roberts University. Jesse manages the Steady Momentum service. Related articles Investment Ideas for Conservative Investors Building A Diversified Equity Portfolio? Understanding Growth Vs. Value Stocks 3 Principles to a Successful Investment Experience Financial Planning Lessons From the Pandemic Risk Depends On Your Time Horizon Buy When You Have the Money, Sell When You Need the Money Cash is (no longer) Trash What’s Wrong With Your 401(k)? (If anything) The Magic of Compounding, and the Tyranny of Taxes Coming To Peace With Market Volatility Coming To Peace With Market Volatility: Part II
Before I dive in, I should generally describe the principles that make up my investment philosophy. I believe markets are not perfectly efficient, but they are highly efficient, where the path to higher expected returns is paved with higher volatility. I believe in factor diversification, so some of this volatility also means occasionally large tracking variance relative to conventional benchmarks such as the S&P 500. There are many ways I diversify my portfolio including asset classes (stocks, bonds, cash, alternative strategies), geography (US, Developed International, Emerging Markets), and risk factors (market, size, value, momentum, profitability, volatility, term) just to name a few. Overall, it's important to have an investment philosophy that you can stick with through tough times. Asset allocation: “Stocks”: 70% Equity mutual funds & ETF's Dual momentum ETF “Bonds”: 8% Bond mutual funds & ETF's “Cash equivalents”: 22% Checking & savings accounts Money Market mutual funds Cash value of life insurance “Alternatives”: 6% Equity index option short strangles This does not include other items that make up my personal net worth such as the present value of a future pension I’ll have from a prior employer, my current equity stake in Lorintine Capital, my home & associated equity, and other valuable personal property and belongings. When I refer to stocks, I’m lumping together certain strategies like passively managed buy/hold/rebalance allocations to equity mutual funds & ETF's and a dual momentum strategy ETF. I don’t own individual stocks as I build my portfolio around academic research which generally advises against buying individual stocks. With bonds, I keep it simple with funds that are short to intermediate term and are high quality. Cash equivalents are pretty straightforward, consisting of checking and savings, although I primarily use my brokerage account like a checking account because the cash balance is automatically swept into a high yield money market mutual fund. I have a debit card and checkbook for this account, ATM fees are rebated, and there are no minimums or transaction count requirements. This part of my portfolio simply acts as my source of short-term liquidity and emergency funds, along with my high yield savings account. If I have any large upcoming lump sum expenditures planned within the next few years, I’ll increase my cash position. I also consider my cash value in a small whole life insurance policy as a source of liquidity because I fund the contract annually up to the IRS “MEC” limit. This would not be recommended for most, as I have a deep understanding of how to make these contracts perform and I’m also a licensed insurance agent. The last asset class in my portfolio is an alternative option strategy known as a short strangle that I implement as an "overlay" to my bond fund holdings. I prefer to sell equity index option strangles as my sole alternative strategy as it's a well documented "alternative risk premium" that should persist in the future. I keep it simple with this strategy, passively selling out of the money XSP puts and calls that are approximately one month from expiration. The historical volatility for my asset allocation over the last 30 years is only about 10% due to the benefits of diversification. The Sharpe Ratio would have been around 0.7 according to backtesting I’ve done, although I have lower forward-looking expectations and would be very happy with 0.6 over the long term. With one month T-bills yielding around 0.1% today, this implies an expected return of approximately 6%. This might sound like a sobering dose of reality to most, but when considering it includes everything that makes up my liquid net worth and the record low interest rate environment we currently live in, I think it's realistic. Jesse Blom is a licensed investment advisor and Vice President of Lorintine Capital, LP. He provides investment advice to clients all over the United States and around the world. Jesse has been in financial services since 2008 and is a CERTIFIED FINANCIAL PLANNER™ professional. Working with a CFP® professional represents the highest standard of financial planning advice. Jesse has a Bachelor of Science in Finance from Oral Roberts University. Jesse manages the Steady Momentum service, and regularly incorporates options into client portfolios.