News and Turtle2

Are Small Cap and Value Tilts Active Bets Against the Market?

News and Turtle2

For the investors who are familiar with the known dimensions of expected return (size, relative-price, profitability, etc.), chances are that you have decided to tilt your portfolio accordingly. IFA’s 100 Index Portfolio also tilts our asset allocation towards small cap and value stocks.

A common misconception amongst professionals and investors alike is that these tilts are “active bets” against the market since we are deviating from a purely market cap weighted asset allocation.

An important distinction needs to be made.

Multiple Dimensions to Risk

First, research has shown that different securities have different expected returns. We would expect this based on fundamental valuation theory. Using the Gordon Growth Model as an example, a securities price is a function of:

  • Current Dividend
  • Growth Rate of Dividend
  • Discount Rate (expected return)

Dividends could also be replaced by other fundamentals, such as book value (assets minus liabilities) for example. Therefore, securities with the same dividend or book value trading at different prices must have different expected returns. Empirical research has identified securities that have systematically delivered higher returns with strong statistical significance. These include small cap stocks, value stocks, and stocks with robust profitability.

Those who are proponents of market efficiency believe these differences in expected return are due to differences in risk profiles. It doesn’t seem too unreasonable to expect that companies like Apple and Blackberry might be assigned different expected returns based on, among other things, the risk associated with their ability to stay in business over the next 1, 3, 5, 10 years or beyond.

If we frame a market cap weighted approach in this light, we can basically say that a market cap weighted asset allocation only sees risk as one-dimensional; mainly, market risk (Beta). But we know that markets are multi-dimensional and that investors can achieve greater expected returns by capturing the many different dimensions of risk.

Matching Risk Profiles

Second, the decision to deviate away from a market cap weighted approach with your personal asset allocation may be due to a desire to seek a different risk profile than that of the entire market.  For those investors who are looking to increase the expected return of their overall portfolio, tilting away from the market cap weighted asset allocation and towards the known dimensions of expected return is a very reasonable approach. What we are NOT saying is that the market is incorrect in its ability to price risk or assess value. What we ARE saying is that we want to take on more risk in order to increase the expected return of our portfolio.

It is important to note that pursuing different dimensions of expected return is not the same thing as stock picking, although it can quickly become that if not used properly. We always advocate for a diversified approach to pursuing market premiums so that investors can isolate the particular risk they are pursuing and not exposing themselves to risk they are not expected to be compensated for (firm specific risk).

For example, taken to the extreme, an investor can decide to hold the smallest, most value oriented stock with robust profitability that exists. While they have attempted to isolate the known dimensions of expected return, they have subsequently opened themselves up to a large amount of risk associated with that particular firm thus decreasing their overall chances of actually capturing the market premiums they are trying to pursue.

How Do We Allocate Risk Across Market Participants?

In order for markets to stay in equilibrium, for every dollar that deviates towards securities with higher expected returns, there must be a dollar that deviates towards securities with lower expected returns. For example, investors at IFA are deviating away from the market cap weighted approach and tilting towards small cap value stocks. There are also large pension funds that are deviating away from the market cap weighted approach and holding mainly large cap stocks. This is an oversimplification of what is actually happening in the market, but underneath the flurry of activity that is constantly happening around the globe, this is essentially the outcome whether investors are aware of it or not.

A great analogy once used by John Cochrane from the Booth School of Business at the University of Chicago is that investors are essentially writing insurance policies to one another. Based on the different expected returns of securities in the marketplace, there are different risk profiles within the market. For every investor who is looking to deviate towards a riskier market cap weighted approach, there are others who want a safer risk profile.

Misconception Among Professionals

Passive investing proponents such as Burton Malkiel have recently come out and said that they are slowly acknowledging the merits of “Smart Beta” strategies that essentially pursue the same dimensions of expected return. In a recent NY Times article, Professor Malkiel talks about his recent enlightenment. Rob Arnott from Research Affiliates developed the “fundamental indexes,” which attempt to break away from a market cap approach to indexing and instead base a stock’s weight on observable fundamentals such as book value, sales, dividend, net income, assets, etc. He is quoted in the article stating, “even though Burt Malkiel was never a die-hard efficient market person, he was pretty staunchly in that camp. He has acknowledged there may be some market inefficiencies, but any advantage from trading on them got eaten up in fees. Now the approach has become so cost-effective that even a skeptic like him is acknowledging it can add value.”

Mr. Arnott’s statement is essentially saying that certain securities have different expected returns based on market inefficiencies, which we respectfully disagree with. Again, different securities have different expected returns based on basic valuation theory involving risk. What Mr. Malkiel is now acknowledging is that markets are multi-dimensional in terms of how they assess risk and moving away from a market cap weighted approach is essentially adjusting your personal risk capacity to the many risk profiles observed in the market.

Conclusion 

As passive investors who are utilizing the known dimensions of expected return within our portfolios, we are not betting against the market. We accept that market prices are a fair representation of the risk associated with each individual company and decide to take on more risk understanding that we are expected to be compensated with a higher return. Different investors have different investment objectives and therefore different risk profiles. A market-cap weighted approach may be sufficient, but not necessarily optimal.