Before we get down to business, it is always good to take a moment for the most important things. In 1776 we were blessed with the opportunity to become a free and sovereign nation. Having achieved that, we were doubly blessed when our Founders wrote and adopted our constitution in 1789, a radical new form of government which ensured the survival of our Republic through many a trial and tribulation.
Lest we overlook the magnitude of that achievement, can you think of a major country with a government older than ours? Thinking… thinking…… time’s up. There isn’t one. As imperfect as our government is, and always has been, it has succeeded in creating reasonably good outcomes for 243 years and counting. And it does so with very imperfect people, as it was designed to do.
Remember, as well, some of the terrible problems we were “born with,” some of which required a terrible civil war to correct, and others of which are still being addressed today. Our Constitution established a robust structure that weathered conflict and tremendous change. It facilitated our conflicts and enabled us to resolve many of them, something most governments do not do well. We have a lot to be thankful for.
On to the business at hand
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We know that our clients have varying degrees of interest in technical investment discussions. This month’s letter will discuss some of the building blocks of our investment approach. As always, those of you less interested in these details are free to skip it entirely.
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Investment Strategy: what happened to the factors?
Before we discuss factors, we should mention that we just finished the best June and the best first half of a year in a very long time [i]. May was kind of scary, but June came roaring back:
Bonds did well too, as interest rates stayed low. This was an excellent month and has been an excellent year so far. [ii] Despite all the headlines about China, trade policy and Fed policy, things worked out pretty well year to date:
But what about those value-added factors?
Dimensional Fund Advisors (DFA) was founded by David Booth in the early 1980’s to create an institutional mutual fund that would capture the returns of the smallest stocks in the U.S. equity markets for huge pension funds. This factor was discovered by his Chicago Business School professor, Eugene Fama, who later was awarded the Nobel Prize for his research.
Naturally that decade turned out to be the worst for small cap stocks ever!
Somehow the theoretical argument that small cap stocks were a legitimate asset class that an institutional investor ought to be exposed to, despite extended periods of underperformance, enabled the fledging company to survive and be in the game when the small cap effect returned with a vengeance in the early 1990’s.
Shortly after the resurgence of the small cap premium in the early 1990s, Fama and Kenneth French killed Beta with their groundbreaking paper describing what came to be known as the “three factor model.” [iii] Prior to this Beta – i.e., market risk, defined as standard deviation – was the single factor driving portfolio returns on the so-called “efficient frontier,” according to another Nobel prize winner, Bill Sharpe. But the Fama/French paper showed that three factors accounted for almost all of portfolio return:
- Exposure to equities (essentially Beta)
- Value – stocks with low prices
- Size – small stocks
When asked about this, Bill Sharpe was allegedly quoted as saying, “I am not giving the Nobel prize back.”
So, what is happening now?
We once again find ourselves in an extended period of factor underperformance. In the 1980’s DFA survived small cap underperformance, and in the late 1990’s we all saw the dot-com boom and the outperformance of large growth (i.e., tech) stocks. Both times the subsequent period saw a dramatic shift back to what we believe to be the source of long-term return and the reversal of recent trends.
The extended periods of small cap underperformance (the red bars), followed by periods of even greater outperformance (the blue bars), are apparent in the below charts. The yearly observations of small caps minus large caps in the U.S. markets are sporadic and nearly evenly distributed between under and overperformance. For the yearly returns, we see that when small caps outperform, they do so, generally, at a greater magnitude. When we take a long-term 5-year view, the value add becomes further noticeably distributed. This trend is even more dramatic for the 10-year returns, but I think you get the idea.
Just as small caps can show periods of underperformance, the same can be said about the value premium. As growth stocks and technology related firms are dominating the headlines with their mega-IPOs and high valuations, value strategies are returning positive results, yet not as large as those of their growth counterparts. We’ve seen this before, and when we did the reversal was dramatic.
There is sound evidence [iv] that value stocks outperform growth stocks over longer periods, but we also know that value and small caps can underperform over any given period, as we are experiencing in recent years. The data speaks for itself in the chart below – which takes a 10-year look at the value premium versus growth. As you can see, value has outperformed growth for the vast majority of 10-year periods since 1937. This recent period has been unusual, but there have been other consecutive 10-year periods of underperformance as well.
We urge clients to remain focused on their long-term goals, tune out the headline noise, and allow the principles of factor investing to do as science and history suggests they will.
For those of you really interested in diving deeply into the details of the returns attributable to factors over periods of time, we will be glad to review with you in person. I would add there is more to it than that, a lot to discuss for those of you who have the interest.
But the quick summary is that your portfolio is doing very well this year and we are monitoring developments on your behalf. Above all, we look forward to discussing with you soon.
i Foimbert. “By the Numbers: Best June for the Dow since 1938, S&P 500’s Best First Half in Two Decades.” CNBC, CNBC, 28 June 2019, www.cnbc.com/2019/06/28/by-the-numbers-best-june-for-the-dow-since-1938-sp-500s-best- first-half-in-two-decades.html.
ii Source: Morningstar Direct, data as of 7/8/19
iii Fama, Eugene F., and Kenneth R. French. “Common Risk Factors in the Returns on Stocks and Bonds.” Journal of Financial Economics, vol. 33, no. 1, 1993, pp. 3–56., doi:10.1016/0304-405x(93)90023-5. https://teamhewins.box.com/s/csvtrtii3np21f7od2l9oz0yznwtet0r
IV Dimensional Fund Advisors, March 2019, https://teamhewins.box.com/s/395a94b90qzd9uagig78d5upe04825lc
Team Hewins, LLC (“Team Hewins”) is an SEC registered investment adviser; however, such registration does not imply a certain level of skill or training and no inference to the contrary should be made. The information contained within this letter is for informational purposes only and should not be considered investment advice or a recommendation to buy or sell any types of securities. Past performance is not a guarantee of future returns. It should not be assumed that diversification protects a portfolio from loss or that the diversification in a portfolio will produce profitable results. The opinions stated herein are as of the date of this letter and are subject to change. The information contained within this letter is compiled from sources Team Hewins believes to be reliable, but we cannot guarantee accuracy. We provide this information with the understanding that we are not engaged in rendering legal, accounting, or tax services. We recommend that all investors seek out the services of competent professionals in any of the aforementioned areas. For detailed information about our services and fees, please read our Form ADV Part 2A, which can be found at https://www.advisorinfo.sec.gov or you can call us and request a copy at (650) 620-3040.
Disclosures for charts:
In USD. Yearly premiums are calculated as the difference in one-year returns between the two indices described. Five- year premiums are calculated as the difference in annualized five-year returns between the two indices described. Small Cap minus Large Cap: Dimensional US Small Cap Index minus the S&P 500 Index. 10-year premiums are calculated as the difference in annualized 10-year returns between the two indices described. Value minus Growth: Fama/French US Value Research Index minus the Fama/French US Growth Research Index. See “Index Descriptions” below.
Eugene Fama and Ken French are members of the Board of Directors of the general partner of, and provide consulting services to, Dimensional Fund Advisors LP. S&P data © 2019 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved.
Dimensional US Small Cap: Index was created by Dimensional in March 2007 and is compiled by Dimensional. It represents a market-capitalization-weighted index of securities of the smallest US companies whose market capitalization falls in the lowest 8% of the total market capitalization of the Eligible Market. The Eligible Market is composed of securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market. Exclusions: Non-US companies, REITs, UITs, and investment companies. From January 1975 to the present, the index also excludes companies with the lowest profitability and highest relative price within the small cap universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Source: CRSP and Compustat. The index monthly returns are computed as the simple average of the monthly returns of 12 sub-indices, each one reconstituted once a year at the end of a different month of the year. The calculation methodology for the Dimensional US Small Cap Index was amended on January 1, 2014, to include profitability as a factor in selecting securities for inclusion in the index.
S&P 500 Index: Measures the performance of large capitalization U.S. stocks. It is a market-value-weighted index of 500 stocks that are traded on the NYSE, NYSE MRK, and Nasdaq.
Fama/French US Value Research Index Provided by Fama/French from CRSP securities data. Includes the lower 30% in price-to-book of NYSE securities (plus NYSE Amex equivalents since July 1962 and Nasdaq equivalents since 1973).
Fama/French US Growth Research Index Provided by Fama/French from CRSP securities data. Includes the higher 30% in price-to-book of NYSE securities (plus NYSE Amex equivalents since July 1962 and Nasdaq equivalents since 1973).