Stone Bar

Dimensions of Expected Return: Patience is a Virtue – 2017 Update

Stone Bar

 

A goal of investment advice should be to educate investors and increase their level of understanding. We do not expect everyone to have a PhD in Economics, so it is important to focus on big ideas that are the most crucial to understand. This can include ideas such as diversification, costs, and discipline.

With that said, we also recognize that many investors who have been engaged with their finances for some time or have a long standing relationship with their wealth advisor, deserve to continually learn more about investing, specifically how Index Fund Advisors manages their money. Today, we are going to venture further down the rabbit hole with the investment strategy that we implement.

The dimensions of expected return is a finer topic that most of our own investors are aware of, but not necessarily the greater population. It is difficult enough to motivate individuals to embrace a passive investment strategy let alone educating them about multiple regressions and time-tested data. Nonetheless, it is extremely important not only from an academic standpoint, but also from a successful investment experience standpoint.

History

Starting in the 1960s, financial economists began researching the behavior of stock prices. Two major events led to this particular movement in the field of economics: the development of computers and the establishment of the Center of Research in Security Prices (CRSP) at the University of Chicago. Economists now had the most comprehensive dataset of stock prices and large machines that could make many computations in a reasonable amount of time. You put these two things together and all of sudden you have an entirely new concentration in the field of economics.

Decades of research and thousands of peer review academic studies of the drivers of stock market returns have led to amazing discoveries about how different types of stocks move in relation to one another. We can slice and dice the market by different factors such as market capitalization, fundamentals like book value or sales compared to market price and region to see how different types of stocks compare to one another around the world. From a practical standpoint, in terms of being able to translate academic findings into actual investment strategies, 4 factors or “premiums” have been found within stocks and successfully implemented (there are 2 factors that drive the behavior of bond prices):

We know that, historically, stocks have outperformed bonds, small cap stocks have outperformed large cap stocks, value stocks have outperformed growth stocks, and stocks that have high profitability have outperformed stocks with low profitability. Furthermore, we have been able to design investment strategies around these different factors.

Now we are not suggesting that focusing on these “premiums” is a free lunch: quite the contrary. Traditional economic theory would suggest that higher expected returns must be associated with higher risk, which we believe is most accurate. Other theories have suggested that these premiums may be associated with behavioral biases, but unfortunately, proponents of the behavioral theory have not presented an economic model to support and test their theory. We are, in essence, pursuing different areas of the market that have been shown to reward investors, but that involves taking risk. As we will show later on, there are periods of time where investors are not rewarded for pursuing these areas in the market, hence, why they are considered “risk premiums.” It is important for investors and advisors to have a healthy respect for these risk premiums when suggesting a particular asset allocation.

Why These 4 in Particular?

Before we go further, it is important to understand that there has been many factors found in academic research, but we stick with these particular 4 factors for the following reasons:

  • They are sensible
  • Persistent across time periods
  • Pervasive across markets
  • Robust to alternative specifications
  • Cost-effective to capture in a diversified portfolio

In other words, there is a very high degree of confidence that investors will benefit from focusing on these particular factors. From a fiduciary standpoint, it is crucial that we only suggest investment strategies that have been shown to be successful through rigorous scientific inquiry.

Historical Performance of These Factors

We now have a general understanding about dimensions of expected return. Historically, investors who have focused on these particular factors within equities have been rewarded with higher returns. Below shows the historical size, relative-price, and profitability premiums for US, International/Developed, and Emerging Markets using the longest dataset available for each market.

For example, within the Emerging Markets Stocks, value stocks have outperformed growth stocks (Relative Price premium) by approximately 4.07% per year from 1989-2016. The highest premium has been the Relative Price premium in International Developed markets, delivering 5.34% per year from 1975-2016. The smallest premium has been the Size premium in the Emerging Markets, delivering 1.81% per year from 1989-2016.

No Such Thing as a Free Lunch

As we mentioned earlier, pursuing these different premiums in the market is no free lunch. If we want to be rewarded with higher expected return, then we have to take risk. While we should expect these premiums to be positive in any year, there are periods of time where they are not. Many clients of IFA are probably well aware that the Relative Price premium (value stocks) in U.S. has not been favorable over the last 10-year period ending 12/31/2016. The charts below show the annual performance for each premium in the U.S. from 1928-2016. A blue bar indicates a positive premium while a red bar indicates a negative premium.

 

As you can see, there are definitely more blue bars than red bars, but there are stretches of time where different premiums do not show up.

Although the average premium observed overtime has been positive, there is extreme variation around that average. For example, just looking at the Relative Price premium in the U.S., we can see that the simple historical average has been 5.13%. There have only been 13 out of 89 calendar years where the observed premium was within 2% of the historical average. See the chart below.

 

The dashed line represents the arithmetic average (5.13%). The gray area around the dashed line represents the 2.00% range around that average. The dark blue bars represent the annual observations that fall within the range (3.13% - 7.13%).

While the average Relative Price premium in the U.S. has been approximately 5%, it is more likely that you will experience a much higher or much lower premium in any given calendar year. The same conclusion holds for the Size and Profitability premiums in the U.S. and around the world.

Patience is a Virtue

While many investors are well aware of diversification in terms of investments, it is also important to understand diversification in terms of time. We diversify our investments as a risk control. Because we do not know with a high degree of certainty which area of the market is going to be the next winner, we hold many different types of stocks. Time diversification is the idea of following a particular investment style over time. As we mentioned before, premiums do not always show up in any given year, but the longer we hold onto them, the likelier we are to capture their benefits.

If instead of looking at 1-year returns we now looked at 5-year rolling returns, how do the premiums in the U.S. look?

 

Each bar shows the 5-year period ending in that particular year. For example, the first red bar under the “Market premium” is for the 5-year period ending 1932. The next red bar is the 5-year period ending 1933 and so on and so forth.

What do you notice?

Compared to the 1-year annual returns shown above, there are less red bars in the 5-year rolling returns. In other words, once we move from looking at premiums from 1 year to 5 years, the probability of seeing a positive premium increases. This is the concept of time diversification.

Again, just to highlight the Relative Price premium in the U.S., below is a chart showing the historical 5-year annual rolling returns.

 

Looks like a smoother ride for the investor versus annual returns.

Following the same logic, what if we looked at 10-year rolling periods in the U.S.?

 

As you can see, this looks even better than the 5-year rolling returns as there are even less red bars across all 4 premiums.

Once again, just to highlight the Relative Price premium in the US, below shows the 10-year annual rolling return.

 

As you can see, once we present the data in terms of 10-year rolling periods, the pursuit of this premium looks very attractive. From 1941-1997, there was not a single 10-year rolling period where value stocks underperformed growth stocks. With that said, you can also see that each of the 10-year rolling periods over the last 6 years has been one of the worst periods for value stocks since the Great Depression. 

The table below shows the historical performance for the Market, Size, Relative Price, and Profitability premiums in the U.S. in terms of having a positive observation.

 

For example, looking at historical 15-year rolling periods for the Market premium, investors have experienced a positive premium 95% of the time. You can see a similar trend across all other premiums.

 

Things Can Turn Quickly

We have already discussed the extreme variability around the historical averages for each premium. This variability means that things can turn either positive or negative rather quickly, highlighting the importance of long-term discipline when pursuing these risk premiums within an investment portfolio. The chart below shows the historical 10-year annual rolling observations for the Relative Price premium sorted from lowest to highest.

 

You can see, for the 10-year period from 2007-2016, the value premium was the third lowest in history (-3.17%). But if we go back just six years and look at the 10-year period from 2001 to 2010, the value premium switches to positive (2.61%). This just emphasizes the importance of having a long-term focus when deciding to pursue these risk premiums within a portfolio.

Conclusion

As advisors it is our duty to constantly educate our clients about the reasoning behind their particular investment strategy. This not only allows us to be transparent, but it is crucial in building long-term investment discipline. Beyond investing in index funds, academic research has found certain factors or premiums within the market that explain the variation in its returns. By pursuing these premiums we can increase the expected return of the portfolio for our investors, but this does not come without accepting a higher degree of risk. Because there is significant variability around these premiums in any given year, it is important to maintain a long-term focus. Historically, the number of positive observations for each premium around the world increases as we increase the time horizon. Because IFA takes a long-term approach to the investment process, pursuing these premiums within our portfolios is expected to be beneficial for our clients with the ultimate goal of creating a positive investment experience.

Should you have any questions in regards to these risk premiums and how we pursue them within your portfolio, feel free to reach out to one of our Wealth Advisors.