How to implement my Small Value tilt?

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How to implement my Small Value tilt?

Postby chipmonk » Sun Mar 24, 2013 11:24 pm

After reading William Bernstein's new short book "Skating where the puck was", and after some reflection, I've (immodestly) decided that I'm one of those young investors who has the means, access, and behavioral/psychological fortitude to benefit from a long-term tilt towards small value. I plan to apply this only to my US stock holdings for now, since I have not been convinced that there is any cost-effective way for me to tilt towards SV internationally.

I currently hold a combination of Vanguard's total market (taxable) and US small-value (Roth IRA) in roughly 4:1 proportion, giving me a moderate tilt towards SV according to Morningstar's Instant Xray:

Code: Select all
My current portfolio        Total US Market
19  19  20                  24  24  25
7   7   5                   6   6   7
11  8   4                   3   3   3


I'd like to increase this tilt substantially in my current holdings and then continue to contribute new money to reach a tilt of around 20% in the SV box. After reading this thread and others on Rydex's RZV ETF, I've decided that there are basically two potentially optimal ways for me to adjust my SV tilt right now: first, to reallocate my holdings to 3:1 TSM:SV, or secondly to maintain my 4:1 TSM:SV but replace my Vanguard SV holding with RZV.

Code: Select all
4:1 VTIAX:VSIAX             3:1 VTIAX:RZV
18  18  18                  19  19  20
7   7   5                   5   5   5
14  9   4                   14  9   4


I'm trying to decide which is the better approach. All the research and discussions I've read indicate that the best way to capture the SV premium is to go as value-y as possible (in favor of RZV) but that it's also important to hold a widely diversified set of value stocks (seemingly in favor of VSIAX, ~1000 stocks vs. ~150).

I am aware of other issues with RZV, such as low trading volume (not a huge concern since I plan to hold for the long run), and questionable long-term tax efficiency (not a concern since I plan to hold in my Roth IRA).

Any advice on which should be the better approach to value tilting for me?
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Re: How to implement my Small Value tilt?

Postby William4u » Sun Mar 24, 2013 11:38 pm

Putting aside the issue of whether or not to tilt, if you are tilting, either strategy is just fine. I use VBR just for convenience of doing it all with Vanguard funds.
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Re: How to implement my Small Value tilt?

Postby nedsaid » Sun Mar 24, 2013 11:50 pm

I am a small value tilter myself. I have 8% myself in the small value box vs 3% for the Total Market Index.

Don't go overboard. Small Value and REITs(which I also believe in) can be unbelievably volatile. Keep in mind that small value can underperform for long periods of time.

The small and value premiums work over long periods of time. They may not work over a decade.
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Re: How to implement my Small Value tilt?

Postby chipmonk » Sun Mar 24, 2013 11:57 pm

nedsaid wrote:I am a small value tilter myself. I have 8% myself in the small value box vs 3% for the Total Market Index.

Don't go overboard. Small Value and REITs(which I also believe in) can be unbelievably volatile. Keep in mind that small value can underperform for long periods of time.

The small and value premiums work over long periods of time. They may not work over a decade.
I appreciate the high volatility and potential for long-term underperformance of SV. My investing timeline is more like 30+ years (when I expect to be in retirement).

I do realize that holding 6-7x the market weight of SV sounds like a very large tilt, but it only means "underweighting" the rest of the market by a factor of 18% (=1-80%/97%). Based on the historical returns and volatilities of different asset classes, an 80% weight to the broad market and a 600% weight to SV corner seems like an aggressive-but-not-insane target to me.
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Re: How to implement my Small Value tilt?

Postby pauliec84 » Mon Mar 25, 2013 12:02 am

I would advise against RZV.

The issue is that while it is smaller and has more value exposure than other ETFs, it has tremendous negative exposure to the momentum factor (UMD).

Code: Select all
ETF, SMB, HML, UMD
RZV 0.900   1.091 -0.299
IJS/VIOV 0.608   0.605 -0.063
VBR 0.572   0.484 -0.047
IWN 0.778   0.512 0.017


The momentum factor historically has a 7% annual premium, so the -0.299 RZV load on momentum factor means ~2.5% lower expected returns.

So put that on top of all the other issuers you had in terms of less tax efficient, higher turnover, higher expense ratio.

It would be a lot more effective to increase your holdings of Vanguard SV. Instead of holding 4:1 hold 3:1. or 2.5:1
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Re: How to implement my Small Value tilt?

Postby nedsaid » Mon Mar 25, 2013 12:16 am

Hey Chipmonk:

You will know your risk tolerance only after you have been through a bear market. Losses on paper in a Monte Carlo simulation are meaningless. It is when you lose real money and feel the real emotional pain that these numbers really mean something to you.

I started out very cautious in my 20's. I started out with a Mutual Fund in a taxable account in about 1984. I had put maybe $1,200 into it when the Stock Market crash hit in 1987. I lost maybe a few hundred dollars that day but to me it felt like I lost all the money in the world. It seems ludicrous now, but the emotional pain was real then. Today, my accounts can fluctuate by thousands of dollars a day. When I lose, it still hurts but I know it is part of investing.

So you might have all the math worked out and intellectually understand the risks. It is when the most sensitive nerve in your entire body, the one in your wallet hurts that your really understand the risks. Human beings are not rational creatures. The emotions we experience are real but make no sense from a rational point of view. Emotions must be taken into consideration.

Just my thoughts. I think you are on the right track.
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Re: How to implement my Small Value tilt?

Postby ClosetIndexer » Mon Mar 25, 2013 1:02 am

chipmonk wrote:I am aware of other issues with RZV, such as low trading volume (not a huge concern since I plan to hold for the long run), and questionable long-term tax efficiency (not a concern since I plan to hold in my Roth IRA).


You might be interested in this post, where I compare historical performance of several tilted portfolios, all with the same overall small and value factors, but constructed using various funds, as well as this follow-up, which thanks to Ketawa, explains that the reason the portfolio based on RZV's index lags the one based on VBR's index is likely due to RZV's significant negative momentum. Given the historical momentum premium of 9.7%, RSV's negative momentum would be expected to account for a drag of about 3% annually. Seems like at least as significant an issue as trading volume or tax efficiency. You might find that whole thread interesting, but there's a lot of analysis, and once you get into it you sort of have to parse the whole thing, since opinions and understanding evolve throughout.
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Re: How to implement my Small Value tilt?

Postby chipmonk » Mon Mar 25, 2013 1:08 am

nedsaid wrote:So you might have all the math worked out and intellectually understand the risks. It is when the most sensitive nerve in your entire body, the one in your wallet hurts that your really understand the risks. Human beings are not rational creatures. The emotions we experience are real but make no sense from a rational point of view. Emotions must be taken into consideration.

Just my thoughts. I think you are on the right track.

I appreciate the cautionary notes. As you say, there's no real way for me to know my risk tolerance other than to experience very large and long-lasting losses.

However, I think the evidence so far is in my favor. In 2008, and again in 2010, I lost around 10% of my total portfolio value at a couple points (approximately 3-5 months' salary around the times of these dips). I didn't blink and just TLH-ed and continued to contribute new money. I think I have a less emotional attitude towards money than almost anyone I know. When I contribute to my investment accounts, I try to imagine that I will never, ever have access to this money again.

Obviously, this is only an ideal, since I have specific but distant goals for my money (buying a house, sending my kids to college, retiring), but I find that this sense of detachment and lack of personal interest helps me manage it more rationally.
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Re: How to implement my Small Value tilt?

Postby chipmonk » Mon Mar 25, 2013 1:32 am

ClosetIndexer wrote:You might be interested in this post, where I compare historical performance of several tilted portfolios, all with the same overall small and value factors, but constructed using various funds, as well as this follow-up, which thanks to Ketawa, explains that the reason the portfolio based on RZV's index lags the one based on VBR's index is likely due to RZV's significant negative momentum. Given the historical momentum premium of 9.7%, RSV's negative momentum would be expected to account for a drag of about 3% annually. Seems like at least as significant an issue as trading volume or tax efficiency. You might find that whole thread interesting, but there's a lot of analysis, and once you get into it you sort of have to parse the whole thing, since opinions and understanding evolve throughout.

Wow, this is a great discussion... thank you for bringing this to my attention! I hadn't seen this thorough analysis before.

I'm rather skeptical of the long-term persistence of the momentum effect, so I pretty much agree with grabiner's conclusion:
grabiner wrote:Conclusion: If you can hold enough VBR (MSCI small value) to get your desired small-cap and value tilt, that is the lowest-cost way to get the tilt. If you can't (limited tax-deferred room, want a larger tilt than VBR itself gives), then use RZV, which requires the smallest holding to get the desired tilt.

It seems like I should be able to get just about as much tilt as I want from VBR especially as I continue to make new contributions to target that allocation.
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Re: How to implement my Small Value tilt?

Postby ClosetIndexer » Mon Mar 25, 2013 2:18 am

chipmonk wrote:Wow, this is a great discussion... thank you for bringing this to my attention! I hadn't seen this thorough analysis before.

I'm rather skeptical of the long-term persistence of the momentum effect, so I pretty much agree with grabiner's conclusion:
grabiner wrote:Conclusion: If you can hold enough VBR (MSCI small value) to get your desired small-cap and value tilt, that is the lowest-cost way to get the tilt. If you can't (limited tax-deferred room, want a larger tilt than VBR itself gives), then use RZV, which requires the smallest holding to get the desired tilt.

It seems like I should be able to get just about as much tilt as I want from VBR especially as I continue to make new contributions to target that allocation.


YW. :) Personally I choose to hold VBR in a taxable account, rather than a smaller amount of RZV in tax-sheltered, but I can certainly see how a case could be made the other way (especially if you expect the momentum premium to drop). From what I can see though, the standard wisdom that SV equates to tax inefficiency does not appear to be terribly applicable here, since Vanguard has done a good job of minimizing capital gains distributions, and the dividend yield of VBR is low. So from that perspective, VBR looks like the safer play. But regardless, I basically agree, and as long as you hit the same factor exposures results are likely to be similar (as that first link I mentioned demonstrates).
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Re: How to implement my Small Value tilt?

Postby chipmonk » Mon Mar 25, 2013 2:50 am

ClosetIndexer wrote:From what I can see though, the standard wisdom that SV equates to tax inefficiency does not appear to be terribly applicable here, since Vanguard has done a good job of minimizing capital gains distributions, and the dividend yield of VBR is low. So from that perspective, VBR looks like the safer play. But regardless, I basically agree, and as long as you hit the same factor exposures results are likely to be similar (as that first link I mentioned demonstrates).
Yeah, that was my bottom-line takeaway from your illuminating discussion: there's little evidence that any SV fund will outperform significantly, but a possibility that the more negative-momentum-laden ones will underperform if momentum persists at its historical levels of return. (Although, since I am a momentum contrarian...)

By the way, I'm not especially concerned about the tax-efficiency of VBR but I do have substantial unrealized gains which make it unwise for me to alter my existing taxable holdings at this point.
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Re: How to implement my Small Value tilt?

Postby jheez » Mon Mar 25, 2013 3:11 am

Just curious... Why do you believe small and value factor (premiums) will exist and not the momentum factor? Momentum has been the most persistent and largest factor historically.
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Re: How to implement my Small Value tilt?

Postby livesoft » Mon Mar 25, 2013 7:20 am

I think that once one decides what they want their M* 9-box style grid to look like, it doesn't really matter too much how they get there. M* is partitioning the actual stocks that funds own into the 9 boxes. So the stocks down in the lower-left small-value corner are pretty much the same for VBR and RZV even if the percentage of those stocks in those ETFs are different.

So I suggest a VTI:VBR ratio as low as 1:1 to get
12 12 12
08 08 04
24 15 05

Full disclosure: Presently, VBR is 43% of my US equity holdings with VNQ (REIT index) another 5%.
It's all about short-term opportunistic rebalancing due to a short-term change in one's asset allocation, uh, I mean opportunistic rebalancing, uh I mean rebalancing, uh I mean market timing.
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Re: How to implement my Small Value tilt?

Postby chipmonk » Mon Mar 25, 2013 11:16 am

jheez wrote:Just curious... Why do you believe small and value factor (premiums) will exist and not the momentum factor? Momentum has been the most persistent and largest factor historically.
Basically, I buy the risk story behind the small and value premiums, and the notion that when companies are small and undervalued it's difficult to correctly value the "long tail" probability that they will grow large and fat. But I see the momentum premium as almost purely behavioral and this makes me skeptical that it will persist indefinitely.
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Re: How to implement my Small Value tilt?

Postby chipmonk » Mon Mar 25, 2013 2:12 pm

livesoft wrote:So I suggest a VTI:VBR ratio as low as 1:1 to get
12 12 12
08 08 04
24 15 05

Full disclosure: Presently, VBR is 43% of my US equity holdings with VNQ (REIT index) another 5%.
Thanks livesoft. May I ask how long you've maintained your very high tilt to SV?
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Re: How to implement my Small Value tilt?

Postby EDN » Mon Mar 25, 2013 2:28 pm

Here is an updated summary of the alpha and risk factor sensitivities for the three primary SV indexes (Russell 2000 Value, S&P 600 Value, and Vanguard Small Value Index) from 2000-2/2013:

Russell 2000 Value
annual alpha = -0.48%
market = 0.92
size = 0.63
value = 0.70
annual return = +9.5%

S&P 600 Value
annual alpha = -0.12%
market = 0.95
size = 0.67
value = 0.54
annual return = +8.9%

Vanguard SV Fund
annual alpha = +0.48%
market = 1.01
size = 0.52
value = 0.61
annual return = +9.3%

So, over this period, the most "factor friendly" fund was the Vanguard Small Value Index, actually outperforming its exposure to market, size, and value by about 1/2% per year. But for someone who didn't want to be mired in the minutia of factor loadings, and just wanted to allocate "X to Small Value", the Russell 2000 Value Index had the highest return--although I only included expense ratios for the Vanguard fund, and we'd probably have to knock off another 0.2% or so for iShares Russell or S&P index returns and 3F alpha.

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Re: How to implement my Small Value tilt?

Postby grabiner » Mon Mar 25, 2013 2:37 pm

EDN wrote:Here is an updated summary of the alpha and risk factor sensitivities for the three primary SV indexes (Russell 2000 Value, S&P 600 Value, and Vanguard Small Value Index) from 2000-2/2013:

Russell 2000 Value
annual alpha = -0.48%
market = 0.92
size = 0.63
value = 0.70
annual return = +9.5%

S&P 600 Value
annual alpha = -0.12%
market = 0.95
size = 0.67
value = 0.54
annual return = +8.9%

Vanguard SV Fund
annual alpha = +0.48%
market = 1.01
size = 0.52
value = 0.61
annual return = +9.3%

So, over this period, the most "factor friendly" fund was the Vanguard Small Value Index, actually outperforming its exposure to market, size, and value by about 1/2% per year. But for someone who didn't want to be mired in the minutia of factor loadings, and just wanted to allocate "X to Small Value", the Russell 2000 Value Index had the highest return--although I only included expense ratios for the Vanguard fund, and we'd probably have to knock off another 0.2% or so for iShares Russell or S&P index returns and 3F alpha.


The factors are based on statistical measures, but in this case, they represent a real difference; here is a comparison of the market cap and value metrics of the small-cap ETFs. The Russell and S&P indexes have a lower cap range than the MSCI index (which holds some mid-caps), and the Russell has a lower price/book ratio.

I still prefer the MSCI index because of the costs; even if you need $15,000 in the MSCI index to get the same small-cap value exposure as $10,000 in the Russell 2000 and $5000 in Total Stock Market, you'll pay less. (And the factor values above suggest that the difference is less than that.)
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Re: How to implement my Small Value tilt?

Postby livesoft » Mon Mar 25, 2013 2:38 pm

chipmonk wrote:
livesoft wrote:So I suggest a VTI:VBR ratio as low as 1:1 to get
12 12 12
08 08 04
24 15 05

Full disclosure: Presently, VBR is 43% of my US equity holdings with VNQ (REIT index) another 5%.
Thanks livesoft. May I ask how long you've maintained your very high tilt to SV?

Since about 2000, but not always with VBR. Lots of tax-loss harvesting along the way, but I also used funds in my 401(k) at times.
It's all about short-term opportunistic rebalancing due to a short-term change in one's asset allocation, uh, I mean opportunistic rebalancing, uh I mean rebalancing, uh I mean market timing.
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Re: How to implement my Small Value tilt?

Postby Default User BR » Mon Mar 25, 2013 6:34 pm

livesoft wrote:I think that once one decides what they want their M* 9-box style grid to look like, it doesn't really matter too much how they get there. M* is partitioning the actual stocks that funds own into the 9 boxes. So the stocks down in the lower-left small-value corner are pretty much the same for VBR and RZV even if the percentage of those stocks in those ETFs are different.

So I suggest a VTI:VBR ratio as low as 1:1 to get
12 12 12
08 08 04
24 15 05

Full disclosure: Presently, VBR is 43% of my US equity holdings with VNQ (REIT index) another 5%.

You inspired me to run up my portfolio numbers. You're a bit more tilty than I am.

16 18 11 | 45
05 06 03 | 14
18 15 08 | 41
__ __ __
39 39 22

I have a more old-fashioned portfolio, with LCB, LCV, SCB, SCV, and REIT.

With ILCB, ILCV, ISCB in:

19 19 12 | 50
07 07 04 | 18
14 12 07 | 33
__ __ __
40 38 23

Might need to up my VSS a bit.


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Re: How to implement my Small Value tilt?

Postby livesoft » Mon Mar 25, 2013 6:45 pm

^The M* style box I showed is not from my portfolio. I like to have between 45% and 50% in large-caps (so the sum of the top row). Clearly, the numbers I gave do not have that. But I do have 43% VBR and 5% VNQ for my US equities. The majority of the rest of my US equities come from Large-cap index and S&P500 index. In particular, I have no SCB since I needed to rebalance into large-caps recently and in my 401(k) exchanged all remaining extended-market index into S&P500.
It's all about short-term opportunistic rebalancing due to a short-term change in one's asset allocation, uh, I mean opportunistic rebalancing, uh I mean rebalancing, uh I mean market timing.
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