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small company index
funds. Investing in these funds is the most efficient and effective way
to maximize exposure to the three risk factors that generate 95% of the
market returns. For example, DFA offers investors value index funds that
are structured to (1) maximize exposure to the size and price risk factors
and (2) diversify that exposure as much as possible. This building block
approach to building portfolios is a cleaner and more consistent way of
managing money.
How a portfolio is structured for optimal exposure to the three risk factors
determines how well the portfolio performs relative to other portfolios.
Portfolio structure refers to the indexes the portfolio holds and in what
proportions. The Fama and French findings offer guidelines to investors for
effectively allocating indexes within a portfolio. The allocation decision
is crucial, since the degree of exposure to the three risk factors for
equities and two additional factors (term and default) for fixed income accounts for nearly all
the returns earned by diversified portfolios of stocks and bonds. That’s
why investors should focus on properly structuring their portfolios rather
than trying to pick winning stocks or managers.
Measuring the Performance of Active Managers
Indexes such as the S&P 500 or Wilshire 5000 are often used to evaluate
the performances of active money managers. Given the Fama and French findings,
the use of such benchmarks is often misleading. Because these indexes
are weighted heavily towards large company stocks and high priced stocks,
the performances of managers investing more heavily in small company stocks
or low priced stocks won’t be accurately measured by them. Instead,
customized benchmarks are needed to provide accurate measurements of the
contributions to performances made by active money managers.
The Fama and French Three-Factor Model is a superior way to evaluate the performances
of active money managers. It shows whether a manager achieves returns
in excess of index returns. After all, an active manager shouldn’t
be rewarded just for buying value stocks—that’s something
that can be done inexpensively with an indexing strategy.
The place where a portfolio is positioned or structured on the crosshair
map in Figure 8-18 determines the vast majority of its return. The crosshair
map doesn’t plot the market risk factor since all stock portfolios
take similar market risk and are plotted relative to the stock market.
So, there’s no need for a separate axis; instead, the stock market
sits right at the crosshairs of the map. The crosshair map has two dimensions.
The size dimension is plotted along the vertical axis, and the value (BtM) dimension
is plotted along the horizontal axis. The axes represent exposure to these
two risk factors. Portfolios that take on a lot of size risk appear higher
along the size axis, and portfolios that take on a lot of value risk appear
further along to the right on the growth/value axis.
Changing the Definition of “Alpha”
The Fama and French Three-Factor (Five Factors with bonds) Model changes the
definition of alpha, as seen in Figure 8-19. According
to the one-factor CAPM, alpha is the amount by which an active money manager
outperforms a broad market index. The Fama and French Three-Factor Model defines
alpha for equities more precisely as the return an active manager achieves
above the sum of the portfolio’s expected return due to all three
equity risk factors. Alpha measures a manager’s skill in earning
a return that couldn’t have been achieved by indexing the same exact
risk exposure as the portfolio run by the manager. In short, did the money
manager earn anything above the indexed return?
A portfolio can be
plotted anywhere on the crosshair map, and it’s easy to calculate
its expected return. For example, a small-cap manager may overweight value
stocks relative to a benchmark, such as the Russell 2000 Small-Cap Index.
As a result, the manager outperforms it. But if the extra return was simply
compensation for taking additional non-diversifiable market risk, why
should the manager get credit? The job of an active manager is to consistently
outsmart the millions of other traders who get the same news at the same
second, and through this process provide additional returns that can’t
be achieved through indexing. This is exactly what t |