Not to flame another Cman/MJG war, but there is definitely another side to this story. Fama-French factors have come into some pretty compelling criticism lately, and it is no longer clear there is a SCV premium or historical outperformance.
First, a
graphic example. (edit: Sigh, looks like M* won't allow you to link to the period I had originally input. To look at that chart, use 6/2
5/1979 as the start date. The values I listed are correct.)
Those are the returns of a $10,000.00 investment in each of VFINX ($474,278.66), NAESX ($434,02
5.38), SCV ($
524,319.28), and LCV ($411,828.31) over the past 3
5 years, approximately the time horizon of a retirement portfolio.
Second, the CAPM model assumes the most efficient portfolio is one that contains all the securities in a market, and that any excess return comes from increased risk. Fama-French expands that by explaining where you find that risk (beta). You aren't increasing your diversification by adding SCV to a portfolio of domestic stocks (if you doubt this, check a correlation table between VFINX and VISVX). You are adding risk in hope of greater returns.
So two questions:
1) Where are the excess returns for the small cap and value premia; and
2) if this investor didn't get greater returns, why did he/she accept greater risk?
As a lot of us probably know this, I'll just link these articles and let people ruminate on their own.
Sam Lee from M* explains Fama-French factors well
here and
here. He also explains his problems with Efficient Market Theory
here. You can find the original paper describing the small-cap premium by Rolf Banz
here.
Turns out, however, that there has been no return premium for small cap stocks since the data was gathered by Banz in 1979. How can that be? Explanations for problems with the Fama-French assumptions, start with their own recent paper explaining how the three factors are actually
five. Ask yourself after, "where does this stop?"
From there you can read:
Sam lee on the Five-Factor model. ("I think this should be a come-to-Jesus moment for those who've taken the F-F model as the gospel truth. Fama and French admit that their original three-factor model was not motivated by theory. They chose value and size because they worked better than other characteristics in back-tests. Grounded in the efficient-market hypothesis, they came up with risk-based stories for these patterns. Small-cap stocks provided excess returns because they're more vulnerable to the business cycle. Value stocks did so because they were distressed.
However, since then, the size factor is no longer considered a significant source of excess returns by many academics and practitioners. Rolf Banz's original 1981 study showing a huge size premium was marred by survivorship bias. After it was corrected in the mid-1990s, back-tests showed a much smaller premium. Moreover, whatever excess returns small-cap stocks provided were driven by the smallest, least liquid securities.")
John Rekenthaler on problems with supposed historical premia. ("To the extent that smaller companies do outperform, those gains likely owe to a liquidity premium. Smaller-company shares have lower trading volume, which increases the chance of moving the stock price by putting in a trade order, and which hampers the investor’s ability to rapidly enter or exit a position. Low liquidity is a real cost that deserves to be compensated with a real return. This is fine--but properly speaking, it’s not a small-company effect.")
Finally these are articles from Advisor Perspectives, a commentary/newsletter service for FAs:
'The Small Cap Falsehood' ("The supposed outperformance of small cap stocks is a foundational precept on which many respected asset managers have staked their expertise over the years – foremost among them, Dimensional Fund Advisors (DFA), the famed fund company that has gained a near-religious following since they popularized small cap indexing three decades ago. A growing body of research, however, shows no such advantage for the last 30 years and, now, a new study seems to have proven that the supposed small-cap advantage may have never existed in the first place.");
and
'A Test for Small Cap and Value Stocks' ("In a recent talk, Stanford professor and Nobel economist Bill Sharpe challenged advocates of smart-beta strategies, including overweighting small-cap and value stocks, to respond to two questions. Can the strategy be adopted by all market participants, or does it have a practical limit in terms of assets that can be invested? If it has a practical limit, then one should expect the premium to decrease over time.
For small-cap stocks, for example, it is obvious that the answer is "no" – eventually the dollars pursuing those stocks would make them mid- or large-cap stocks. The same is true for value stocks; the money pursuing them will eventually drive prices up and erase their risk premium.
In an email exchange, [Larry] Swedroe essentially agreed.")
It should be pointed out that Merriman has an agenda here: he sells DFA funds that are uniquely based on the Fama-French factors. To be fair, those funds have done very well since inception. It is worth asking, however, if the small cap premium is based in liquidity and not size, whether an index is the best method of including this asset class in a portfolio.
It should also be said that the one factor that is predictive of future performance is valuation as measured by Shiller CAPE. And right now, US small caps have historically high valuations.
So should someone include SCV? That depends on what their horizon and goals are. But if they do weight to SCV, they should be aware they are accepting increased risk with no guarantee of increased returns.
