Equius Partners give EM equity the boot

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Robert T
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Equius Partners give EM equity the boot

Post by Robert T »

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Another Look at Emerging Markets
We can no longer make a case for including emerging markets in a portfolio. A realistic longer term view reveals a very disappointing return history coupled with significant and unique risks. More recently, hot money has taken hold of emerging markets and they now represent the highest-priced asset class around. With a far superior alternative in U.S. and international small value stocks, we have made the decision to remove emerging markets from our portfolios.
Not that I totally agree with the article - but always interesting.

Robert
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Post by fishndoc »

The most definitive study on the relationship between investment returns and economic growth came from three academics at the London Business School earlier this decade. Dimson, Marsh, and Staunton looked at 17 different countries over 100 years, , and concluded that stock markets of the slowest growing economies outperformed the markets of the fastest growing economies by 3% per year.1
A second study that measured the last few decades and covered 53 countries (to include some emerging markets) showed an even wider disparity—(the stock market returns of) the slowest growing economies outpaced the fastest growers by 6% annually!
For myself, I've been torn between the advise of the two authorities I most respect: William Bernstein, who pretty much echos the above quote, and David Swensen, who now, I believe, recommends 40% of one's International equities be in EM.

For now, I've split the difference between market weight (20%) and Swensen's recommendation, and have 30% of my International allocation in EM. If I move either way in the future, it will likely be lower EM.

Wayne
" Successful investing involves doing just a few things right, and avoiding serious mistakes." - J. Bogle
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Post by jeffyscott »

they now represent the highest-priced asset class around
Interesting statement coming from Jeff Troutner's firm, I had thought he did not really believe that one could know such things...expected returns, etc. But maybe I am mistaken.

I'm planning to phase out a dedicated emerging markets stake, myself. I'll just let fund managers decide on that allocation. I am doing the same with REITs, which have had similar volatility to EM.

I believe Jeff T. was the only financial advisor, amongst those who have participated in discussions here and at m*, that was always opposed to investing in REITs.
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Post by Robert T »

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Economic growth and stock returns: IMO the EM growth and stock return relationship is less clear cut than is often made out to be.
  • First: On the 53 country study (re: the 6% high growth-low growth quintile difference), the quintiles used (10-11 countries each) are annually reconstituted based on growth rates of the past 5 years. The key result has more to do with the slowest growing than the fastest growing countries. i.e. the 10-11 slowest growing countries over the last 5 years had current year returns 5-6% higher than the average for the remaining 42 countries (the variation of returns among the quintiles of the remaining 42 countries was relatively small – about 1%). (see Brandes paper).

    Second: All but one country in the highest growth quintile in 2004 (according the earlier linked Brandes paper) were emerging market countries. These countries had the highest economic growth rates over the previous 5 years (2000-04), a period when they also has highest relative stock returns (2000-04 annualized return: EM = 5.3%, US = -1.4%, Europe = 0.1%). So it seems to be about the difference in expectations about future (earnings) growth and actual growth (and associated risks), rather than the absolute growth numbers.

    Third: The only emerging market today in the referenced 100 year Dimson et al. study is South Africa which from 1900 to 2000 had an annualized real equity return of 6.8%, compared to the ‘world’ annualized real equity return of 5.8%. South Africa’s real GDP per capita growth from 1900-2000 was 0.9 percent, close to half the growth of any other country in the Dimson et al study. So the only long-term EM observation we have, doesn’t match the EM high growth–low return story.
And just as an aside on the EM roach model: EM stocks do check out – when they have grown so much they migrate to become developed market stocks (just as small caps migrate to become large caps IMO).

In 2003 I set up a long-term EM asset allocation target (13 percent of equities). No need to change it now. My long term EM expected return in 2003 was 9 percent annualized, since then the actual returns have been 21 percent annualized – so I must be expecting future returns to be signficantly lower than 9 percent. EM equities have added diversification, have performed no worse the Intl SV in a portfolio context over longer periods, and have been more tax-efficient. But just my take.

Robert
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peter71
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Post by peter71 »

I'm pro-EM (EM small value in particular) but I did like the point about large cap EM funds lacking the "self purge" mechanism of US small value funds.

On the growth-investment returns relationship I think we just need more research than the two studies that always get quoted . . . the main theoretical argument I've heard for why growth would hurt investment returns is that it forces innovation and cap expenditure at the expense of dividends. But while that makes a certain sense to me I suspect that the pressures to innovate on GM, Cisco and US Steel may be greater than those on a newer EM concern that benefits from what's sometimes been called "the advantages of economic backwardness" (basically, just the advantage of starting a company later and not having huge sunk costs in 30 year old plant and equipment . . .)

http://isites.harvard.edu/fs/docs/icb.t ... enkron.pdf

The old results are what they are but it'd be interesting to see trends in subperiods of the data over time, different types of production (e.g., service vs. manufacturing) and controlling for wage and unionization factors . . . if the correlation between growth and investment returns between 2000 and 2010 turns out to be just as negative as it was between 1900 and 1910 that'd be interesting, but personally I'd be surprised if that's so. Actually, I'm not sure there's any 1900-1910 data on emerging market stock returns in the first place, and that may be suggestive in itself . . .

Blah, blah, blah, etc. :D

All best,
Pete

P.S. Robert, our posts crossed, but thanks for looking into this a little more. On the self purge / roach motel I see what you're saying but I guess the counterexample would be a very pricey company in a country that's nowhere near entering developed market status (a status that, after all, they're still typically denying to South Korea and Taiwan).
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Post by jeffyscott »

Robert T wrote:EM stocks do check out – when they have grown so much they migrate to become developed market stocks (just as small caps migrate to become large caps IMO).
Stocks do not become developed market stocks based on increased market cap. They'd only become that if the company moved or if the country became a developed market, neither of which events have anything to do with the market cap of the stock.
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Post by Robert T »

jeffyscott wrote:Stocks do not become developed market stocks based on increased market cap. They'd only become that if the company moved or if the country became a developed market, neither of which events have anything to do with the market cap of the stock.
Let me rephrase to try to clarify the shorthand.

EM stocks do check out (not just into bankrupcy). When a country migrates from emerging market status to developed market status so do its stocks i.e. they migrate to become developed market stocks. Countries will likely migrate when they have had an extended period of high growth (when GDP and stock market cap will likely be larger). Bernstein likened emerging markets to growth stocks: “just as growth stocks have lower returns than value stocks, so do growth nations have lower returns than value nations...” I think they are more like small cap stocks [perhaps even like higher risk value stocks over long term – 15 of 36 exchanges existing in 1901 are still considered emerging] so in a similar comparison – just as small cap stocks migrate to large cap stocks, so do ‘small cap’ nations’ migrate to ‘large cap’ nations. Obviously no guarantees that they will.
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Post by statman »

Several posts have hinted at a fact that should influence decisions about EM. Namely, EM is not a well-defined asset class with characteristics that distinguish it. It makes no sense to regard South Korea and Taiwan as "emerging" but Greece and Portugal as "developed." The EM class is artificial, and when the artificial boundary changes -- e.g. when South Korea and Taiwan are at last recognized as having emerged -- EM funds must make perhaps significant changes in their portfolios. I prefer to lump all non-dollar equity markets together for asset allocation purposes. This leads to choices such as Vanguard's FTSE All World Ex-US Small-Cap Index fund.
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Post by stratton »

statman wrote:Several posts have hinted at a fact that should influence decisions about EM. Namely, EM is not a well-defined asset class with characteristics that distinguish it. It makes no sense to regard South Korea and Taiwan as "emerging" but Greece and Portugal as "developed." The EM class is artificial, and when the artificial boundary changes -- e.g. when South Korea and Taiwan are at last recognized as having emerged -- EM funds must make perhaps significant changes in their portfolios. I prefer to lump all non-dollar equity markets together for asset allocation purposes. This leads to choices such as Vanguard's FTSE All World Ex-US Small-Cap Index fund.
In 1993 both Greece and Portugal were EM countries. There are also different degrees of Developed and EM nations. Recently Greece and Portugal were moved down one degree on the developed nation list by one of the indexes. SK and Taiwan were moved up a degree from "normal" EM countries along with Singapore.

Paul
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Post by grok87 »

Robert T wrote:.=

Third: The only emerging market today in the referenced 100 year Dimson et al. study is South Africa which from 1900 to 2000 had an annualized real equity return of 6.8%, compared to the ‘world’ annualized real equity return of 5.8%. South Africa’s real GDP per capita growth from 1900-2000 was 0.9 percent, close to half the growth of any other country in the Dimson et al study. So the only long-term EM observation we have, doesn’t match the EM high growth–low return story.
Not following sorry- didn't South Africa have low growth and better returns? Can you explain your point again?
thanks
cheers,
RIP Mr. Bogle.
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Post by Robert T »

grok87 wrote:Not following sorry- didn't South Africa have low growth and better returns? Can you explain your point again?
Sure. One argument put forward against EM equity seems to be: emerging market economies have higher long-term growth than developed market economies. Then, its argued, as economic growth and stock returns are negatively related, EM equity has lower expected return (likened to 'growth stocks').
  • (i) its not clear (at least to me) that the Dimson 53 country study conclusively demonstrated that EM countries have higher growth and lower stock returns than developed market economies (as in my earlier post).

    (ii) even if there is a relationship between EM economic growth and stocks returns, the only 100 yr data point we have of a current emerging market country seems to suggests the opposite of what is claimed i.e. instead of the EM country having higher long-term growth and lower long-term stock returns, South Africa had lower long-term growth and higher long-term returns (see figure 1, pg. 494): suggesting more 'value stock' like characteristics than 'growth stock' like characteristics over the last 100 years (again seems to be the opposite of what is suggested for the characteristic of emerging markets in arguments against them). Obviously this is just one data point.
Not sure if this clarifies.

Robert
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Post by Adrian Nenu »

http://bloomberg.com/apps/news?pid=2060 ... g32Og4_vdU
Among the BRICs, “China is the best because of the growth in the economy,” said Mark Mobius, who oversees about $25 billion as Singapore-based executive chairman at Templeton Asset Management Ltd., in an interview. “I think there will be a lot of surprises next year in terms of recovery.”
“China is where we are putting most of our money out of the BRICs,” Peter Schiff, president and chief global strategist for Darien, Connecticut-based Euro Pacific Capital, whose clients have more than $2 billion in assets, said in a telephone interview. “Valuations are certainly better there. That is where the growth and profits are going to be.”
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Post by grok87 »

Robert T wrote:
grok87 wrote:Not following sorry- didn't South Africa have low growth and better returns? Can you explain your point again?
Sure. One argument put forward against EM equity seems to be: emerging market economies have higher long-term growth than developed market economies. Then, its argued, as economic growth and stock returns are negatively related, EM equity has lower expected return (likened to 'growth stocks').
  • (i) its not clear (at least to me) that the Dimson 53 country study conclusively demonstrated that EM countries have higher growth and lower stock returns than developed market economies (as in my earlier post).

    (ii) even if there is a relationship between EM economic growth and stocks returns, the only 100 yr data point we have of a current emerging market country seems to suggests the opposite of what is claimed i.e. instead of the EM country having higher long-term growth and lower long-term stock returns, South Africa had lower long-term growth and higher long-term returns (see figure 1, pg. 494): suggesting more 'value stock' like characteristics than 'growth stock' like characteristics over the last 100 years (again seems to be the opposite of what is suggested for the characteristic of emerging markets in arguments against them). Obviously this is just one data point.
Not sure if this clarifies.

Robert
.
thanks that's very helpful,
cheers,
RIP Mr. Bogle.
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Post by Kenster1 »

Robert, thanks for that update from their Sept newsletter. Did you also see their Oct newsletter? Interesting article on using Smallcap Value in portfolios.

Here's Mobius' recent thoughts....and of course he's still positive on Emerging Markets.

http://www.bloomberg.com/apps/news?pid= ... Uox4&pos=6
Nov. 18 (Bloomberg) -- Mark Mobius said stocks in Brazil, Russia, India and China are likely to rise by 30 to 40 percent within three to four years as higher economic growth and lower government debt spurs corporate earnings.

Mobius, chairman of Templeton Asset Management Ltd., said he’s increasing holdings in all emerging markets, with particular focus on the four biggest developing-nation economies collectively known as the BRICs.
The MSCI Emerging Markets Index of 22 developing countries added 0.4 percent to 984.26 as of 4:10 p.m. in London, poised for the highest closing level since Aug. 11, 2008. The index is valued at 20 times reported earnings, according to data compiled by Bloomberg.

The MSCI China Index trades at 17.7 times profit, while the MSCI Brazil Index is valued at 18.5 times earnings. That compares with a price-earnings multiple of about 30 for the MSCI All Country gauge of developed and emerging economies. The S&P 500 is valued at 22 times profit of the companies in the index.
SURGEON GENERAL'S WARNING: Any overconfidence in your investing ability, willingness and need to take risk may be hazardous to your health.
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Post by dbonnett »

Isn't giving up on EM market timing?
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Post by Robert T »

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Kenster,
Did you also see their Oct newsletter?
Yes I did. While I respect Jeff, and have learned from his writings, I don’t totally agree with his take on ETFs (from the Oct 'asset class'):
  • “Investing in ETFs that are based on inferior underlying indexes might earn you an ETF-marketing merit badge, but it doesn’t add value for your clients, no matter how much you might discount your fee.”
I don’t think many/most of the common indexes are inferior. While I agree this may be the case for some indexes (perhaps Russell), I don’t think this extends to ETFs that track MSCI and S&P value (cap weighted) indexes. I think they will do just fine (based on my analysis) and use them for my own investments.

FWIW here’s a comparison of two portfolios with the same stock:bond and US:EAFE:EM allocation, as well as the same estimated factor loads (value, size, term, default) across these global markets (the same estimated factor loads in each market). These are as best as I could estimate (correction welcome). One is based on ETFs, and one using some of the DFA Tax Managed funds. Not much of a difference in recent performance (or IMO on expected performance). “What matters over the long-haul is factor exposure and expense” - from Bill Bernstein. Time will tell.

Recent returns (%) of ETF and DFA portfolios with same estimated factor loads.

....................................last 6 months...................last 12 months
ETF......................................19.92.........................43.84
DFA Tax Managed................19.45.........................41.94

The difference perhaps simply reflects errors in the factor load estimates.

Robert
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Post by gizzsdad »

dbonnett wrote:Isn't giving up on EM market timing?
Yes. A respected friend told me about 10 years ago he saw no reason to use EM - as the returns(at that point) did not justify their volatility.

I decided to use EM anyway, and have maintained an 8-12% allocation. For this I am very thankful, as I just checked today and the 10 year returns for my EM fund have averaged about 12%. I haven't done an exhaustive study, but I would imagine they have been the biggest positive contributor to my portfolio over that time frame.
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Post by ScottW »

Robert T wrote:I don’t think many/most of the common indexes are inferior. While I agree this may be the case for some indexes (perhaps Russell), I don’t think this extends to ETFs that track MSCI and S&P value (cap weighted) indexes. I think they will do just fine (based on my analysis) and use them for my own investments.
While I believe the MSCI and S&P are more "investable" than their Russell counterparts, I think we can agree that there are benefits to using a proprietary index designed for investing where additions and deletions are not publicized in advanced, and the funds have more leeway when buying and selling securities.

Consider Vanguard's Tax-Managed Smallcap fund and iShares S&P 600 ETF. Both are based on the S&P 600 index, yet consider their 5-year annualized performance and tax cost:

Vanguard: Pre-tax 1.35%, After-tax 1.20%, tax cost 0.15
iShares: Pre-tax 1.14%, After-tax 0.79%, tax-cost 0.35

Despite having the capital gains benefit inherent to ETFs, the iShares product had both a lower pre-tax return and a higher tax cost. 3-year results are similar. 39 basis points isn't a lot, but it illustrates that passively funds with a little "active" management could add value than an ETF strictly following an index cannot. The question is how much.

Having said that, I still use ETFs for my own portfolio.
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Post by hafis50 »

The paper mentions all sorts of political and economic risks but it concludes that the higher risks are not related to higher expected returns.

Exactly this relation is used to recommend investments in small value.

Not logically consistent if you believe in market rationality.

Bernstein wrote in 1997:
"There may be a correlation between economic or political data and returns, but it is weak and most likely negative. Even the most cursory examination of market history shows that economic optimism is often a precursor of poor returns (1929, 1966) and that economic
disaster (1932, 1974, 1982) is usually a recipe for high returns. In the global marketplace, Cambell Harvey has recently shown that nations with high perceived political and economic instability have higher returns than more stable nations. This should not surprise -- the fundamental investment equation is the positive correlation of risk and return." (page 14, emphasis mine)



Therefore, what sense does it make to use an economic data to define a financial asset class?
We use beta and FF-factors in developed markets and growth and income in EM??

In Campbell Harvey's model the return on an integrated market depends on its covariance with the world risk factor.
Emerging markets are not (fully) integrated and they may have higher expected returns because local investors may demand higher returns if there are fewer opportunities to diversify.

The higher returns during the early 1990s that Equius papers mention could be explained by a lesser degree of integration.

The paper does not explain why these markets were and will be inefficiently priced (high risks without high expected retunrs).

P.S.: i believe fads and bubbles can exist in these markets.
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Post by the fixer »

Robert T wrote:.
Kenster,
Did you also see their Oct newsletter?
Yes I did. While I respect Jeff, and have learned from his writings, I don’t totally agree with his take on ETFs (from the Oct 'asset class'):
  • “Investing in ETFs that are based on inferior underlying indexes might earn you an ETF-marketing merit badge, but it doesn’t add value for your clients, no matter how much you might discount your fee.”
I don’t think many/most of the common indexes are inferior. While I agree this may be the case for some indexes (perhaps Russell), I don’t think this extends to ETFs that track MSCI and S&P value (cap weighted) indexes. I think they will do just fine (based on my analysis) and use them for my own investments.

FWIW here’s a comparison of two portfolios with the same stock:bond and US:EAFE:EM allocation, as well as the same estimated factor loads (value, size, term, default) across these global markets (the same estimated factor loads in each market). These are as best as I could estimate (correction welcome). One is based on ETFs, and one using some of the DFA Tax Managed funds. Not much of a difference in recent performance (or IMO on expected performance). “What matters over the long-haul is factor exposure and expense” - from Bill Bernstein. Time will tell.

Recent returns (%) of ETF and DFA portfolios with same estimated factor loads.

....................................last 6 months...................last 12 months
ETF......................................19.92.........................43.84
DFA Tax Managed................19.45.........................41.94

The difference perhaps simply reflects errors in the factor load estimates.

Robert
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I don't think the two portfolios above are that close in actual tilts, which probably does explain similar returns over a short period. With less of a value orientation and no int'l small cap exposure at all on the DFA side, the ETF and DFA portfolios look to be apples and pears. Also, I cannot imagine someone actually investing in the proposed DFA portfolio, with 0% US large growth exposure, but a healthy dose of EAFE?

A far superior comparison over an admittedly meaningless short period of time would be the first comparison developed a year ago between the ETF portfolio and the DFA Vector portfolio which has moderate consistent tilts in US, international, and emerging markets stocks, very close and consistent with the ETF allocation. And not surprisingly, that portfolio has exceeded the ETF set up by about +7% in the last year. Realistically over time , 1% to 2% is not unreasonable when you consider lower trading costs associated with Core, intelligent management of momentum with an eye towards patient trading but consistent factor exposure, and screens that help minimize superflous sectors like REITs and regulated utilities.

As a matter of fact, the biggest mismatch in that example is in the bond camp between the Five Year Global fund from DFA and the Treasury ETF from iShares, but using DFA Int'd Government wouldn't have changed the results at all, as Five Year and Int'd Gov have had similar returns over the last 12 months.
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Post by Robert T »

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The argument for DFA funds has often been DFA adds on average about 1% alpha per year above factor exposure (or perhaps loses less alpha than any other fund portfolio) i.e. would outperform an ETF portfolio with the same factor exposure by 1%. If I recall there have been several posts on this forum comparing DFA and ETF portfolios that seem to conclude that the DFA portfolio outperforms by about 1%. Similar to the suggestion in the above post: “Realistically over time, 1% to 2% is not unreasonable when you consider lower trading costs…, intelligent management of momentum with an eye towards patient trading but consistent factor exposure, and screens that help minimize superflous sectors like REITs and regulated utilities.”

The tracking of the ETF and DFA portfolios was an attempt to test this claim/hypothesis with two portfolio with as close to the same factor loads as I can get (together with similar expected tax efficiency). These are based on estimates of factor loads (from historical data). If someone can come up with a closer matched factor load comparison please post, with the historical factor load estimates. Here are the estimates used for the ETF and DFA tax-managed portfolio.

Code: Select all


Factor load and expected returns used in the portfolio comparison

                           
ETF Portfolio
----------- 
Vanguard Midcap Value        0.234 * (1.00 * 6.5) + (0.10 * 2.0) + (0.65 * 4.0) 
iShares S&P600 Value       + 0.094 * (1.00 * 6.5) + (0.65 * 2.0) + (0.60 * 4.0) 
Bridgeway Ultra Small Co.  + 0.047 * (1.00 * 6.5) + (1.10 * 2.0) + (0.10 * 4.0) 
iShares EAFE Value         + 0.234 * (1.00 * 7.0) + (-0.1 * 2.0) + (0.35 * 4.0) 
iShares EAFE Small Cap     + 0.047 * (1.00 * 7.0) + (0.90 * 2.0) + (0.10 * 4.0) 
Vanguard EM                + 0.094 * (1.00 * 9.0) + (0.00 * 2.0) + (0.00 * 4.0)      
iShares Lehman 3-7 Trsy    + 0.250 * (1.00 * 3.7) + (0.00 * 0.5) + (0.50 * 1.6) 

EXPECTED RETURN [4]        = 7.9% 


DFA Tax-Managed Portfolio
----------- 
DFA TM US MktWide Value      0.170 * (1.00 * 6.5) + (0.00 * 2.0) + (0.70 * 4.0) 
DFA TM US Targeted Value   + 0.070 * (1.00 * 6.5) + (0.50 * 2.0) + (0.80 * 4.0) 
DFA TM US Small            + 0.135 * (1.00 * 6.5) + (0.85 * 2.0) + (0.30 * 4.0) 
DFA TM Intl. Value         + 0.170 * (1.00 * 7.0) + (0.10 * 2.0) + (0.50 * 4.0) 
DFA Lntl. Large cap        + 0.110 * (1.00 * 7.0) + (-0.1 * 2.0) + (0.00 * 4.0) 
DFA EM                     + 0.095 * (1.00 * 9.0) + (0.00 * 2.0) + (0.00 * 4.0)      
DFA Int. Government        + 0.250 * (1.00 * 3.7) + (0.00 * 0.5) + (0.60 * 1.6) 

EXPECTED RETURN            = 7.9%

Note: The equity fund numbers above reflect: weight *  (b * beta)   + (s  * SmL)  + (h * HmL). The bond fund numbers above reflect: weight * (Rf) + (d * Default) + (t * term).          


Here’s a summary of the estimated factor load regional breakdowns from the above table:

Code: Select all

                              Size load   Value load   Term load  
ETF Portfolio
------------
  US equity                       0.36        0.57
  Non-US developed equity         0.07        0.31
  EM equity                       0.00        0.00  
  ------------------------------------------------
  Total equity                    0.21        0.40
  Fixed income                                             0.60

DFA Tax-Managed Portfolio
------------
  US equity                       0.40        0.57 
  Non-US developed equity         0.02        0.30
  EM equity                       0.00        0.00
  ------------------------------------------------ 
  Total equity                    0.21        0.40
  Fixed income                                             0.50

 
Following the above, I disagree with the previous poster. I think the two portfolios have very similar factor loads. And provide a more meaningful comparison over shorter time periods than with a DFA portfolio with markedly different regional and overall portfolio factor loads (as in the DFA vector portfolios), where the short-term differences are expected to be much higher.

Not surprisingly, given the very similar estimated factor loads, the returns have been similar. Just checked again (table below). Or put another way, the very similar portfolio returns seem to suggest that my factor load estimates were not too far off. “What matters over the long-haul is factor exposure and expense” – Bill Bernstein

Code: Select all


Returns (%) - as of 11/22/09

                     Last 6 months     Last 12 months
  
ETF                    18.87              40.83
DFA Tax-Managed        18.53	           40.16

Will continue to track performance. Time will tell whether the claimed/hypothesized 1 (to 2)% DFA outperformance over longer time periods materializes.

Robert

Disclosure: My retirement portfolio is largely comprised of ETFs, while 529 savings are in DFA funds (WV529).
Last edited by Robert T on Mon Nov 23, 2009 8:01 am, edited 2 times in total.
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Post by neverknow »

..
Last edited by neverknow on Mon Jan 17, 2011 6:11 am, edited 1 time in total.
the fixer
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Post by the fixer »

Code: Select all


Factor load and expected returns used in the portfolio comparison

                           
ETF Portfolio
----------- 
Vanguard Midcap Value        0.234 * (1.00 * 6.5) + (0.10 * 2.0) + (0.65 * 4.0) 
iShares S&P600 Value       + 0.094 * (1.00 * 6.5) + (0.65 * 2.0) + (0.60 * 4.0) 
Bridgeway Ultra Small Co.  + 0.047 * (1.00 * 6.5) + (1.57 * 2.0) + (0.85 * 4.0) 
iShares EAFE Value         + 0.234 * (1.00 * 7.0) + (0.0 * 2.0) + (0.40 * 4.0) 
iShares EAFE Small Cap     + 0.047 * (1.00 * 7.0) + (1.10 * 2.0) + (0.10 * 4.0) 
Vanguard EM                + 0.094 * (1.00 * 9.0) + (0.00 * 2.0) + (0.00 * 4.0)      
iShares Lehman 3-7 Trsy    + 0.250 * (1.00 * 3.7) + (0.00 * 0.5) + (0.50 * 1.6) 


DFA Tax-Managed Portfolio
----------- 
DFA TM US MktWide Value      0.170 * (1.00 * 6.5) + (0.10 * 2.0) + (0.56 * 4.0) 
DFA TM US Targeted Value   + 0.070 * (1.00 * 6.5) + (0.60 * 2.0) + (0.54 * 4.0) 
DFA TM US Small            + 0.135 * (1.00 * 6.5) + (0.77 * 2.0) + (0.18 * 4.0) 
DFA TM Intl. Value         + 0.170 * (1.00 * 7.0) + (0.05 * 2.0) + (0.6 * 4.0) 
DFA Lntl. Large cap        + 0.110 * (1.00 * 7.0) + (-0.1 * 2.0) + (0.00 * 4.0) 
DFA EM                     + 0.095 * (1.00 * 9.0) + (0.00 * 2.0) + (0.00 * 4.0)      
DFA Int. Government        + 0.250 * (1.00 * 3.7) + (0.00 * 0.5) + (0.60 * 1.6) 


Note: The equity fund numbers above reflect: weight *  (b * beta)   + (s  * SmL)  + (h * HmL). The bond fund numbers above reflect: weight * (Rf) + (d * Default) + (t * term).          


Here’s a summary of the estimated factor load regional breakdowns from the above table:

Code: Select all

                              Size load   Value load   Term load  
ETF Portfolio
------------
  US equity                       0.37        0.66
  Non-US developed equity         0.14        0.26
  EM equity                       0.00        0.00  
  ------------------------------------------------
  Total equity                    0.20        0.45
  Fixed income                                             0.60

DFA Tax-Managed Portfolio
------------
  US equity                       0.43        0.42 
  Non-US developed equity         0.00        0.30
  EM equity                       0.00        0.00
  ------------------------------------------------ 
  Total equity                    0.21        0.36
  Fixed income                                             0.50

 
I have adjusted the factor loads listed above to reflect the longest available data for each index or asset class in question. Observations over a few years can be very volatile and unreliable, and one of the major benefits of index investing is an ability to review risk factor tendencies over much longer periods of time to increase confidence in observations, even if funds weren't available to track that index.

There are many ways to bring a DFA portfolio closer to the ETF allocation listed above, I just don't believe the one proposed above is one of them. One example would be to use 20% TA US Core 2, 25% TM Marketwide Value, 5% TM Targeted Value, 17% TA World xUS Core, 20% TM Int'l Value, 4% Int'l Small Value, and 9% Emerging Markets on the stock side and 25% Int'd Government on the fixed side. A quick glance has that portfolio about 1.7% ahead of the ETF allocation for the last 12 months.

Various allocations I looked at were in this range, from almost 2% for the mix above to as much as 7% or 8% for the Vector-like allocations suggested earlier. Can't say much about 1 year returns, however. Especially considering how much cross sectional dispersion existed.
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Post by Lbill »

I'd be interested in the role played by currency in the USD denominated returns of EM. Anybody have this info? Regarding currencies, it's interesting to note that the Chinese renminbi is pegged to the USD - what would the returns for the Chinese market be if the renminbi had been allowed to float? That's also a question for the future. If the renminbi is allowed to float and it strengthens vs. the USD, then dollar-denominated returns of Chinese stocks will be juiced by the currency factor alone. I'm somewhat inclined to buy a little of Malkeil's China small cap ETF as a bet on the renminbi. Guess that would put me in Jim Roger's camp.
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Post by Robert T »

.
We simply get different estimates of the factor loads. I will post my individual fund results (time periods, etc) when I have more time. In all the analysis I have done I simply don't see the 1 to 2% you always seem to conclude with... Now there may be many credible arguments to own DFA funds, but the 1 to 2% outperformance beyond factor exposure is not one of them in my view (based on fairly extensive analysis).

I think it is more accurate to use the same/similar time periods for estimates of factor loads across funds. i.e. what where their characteristics under similar conditions/same time periods (more apples to apples comparison to me). For example – do you really believe that the MSCI midcap value series and S&P600 value have higher value loads (50:50ish sort) than the DFA Mktwide value and Targeted value series (30:30 sort)? A varying time period analysis may suggest this is the case (your reported results), but analysis of the same time period will likely not (closer to my results).
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Post by the fixer »

Robert T wrote:.
We simply get different estimates of the factor loads. I will post my individual fund results (time periods, etc) when I have more time. In all the analysis I have done I simply don't see the 1 to 2% you always seem to conclude with... Now there may be many credible arguments to own DFA funds, but the 1 to 2% outperformance beyond factor exposure is not one of them in my view (based on fairly extensive analysis).

I think it is more accurate to use the same/similar time periods for estimates of factor loads across funds. i.e. what where their characteristics under similar conditions/same time periods (more apples to apples comparison to me). For example – do you really believe that the MSCI midcap value series and S&P600 value have higher value loads (50:50ish sort) than the DFA Mktwide value and Targeted value series (30:30 sort)? A varying time period analysis may suggest this is the case (your reported results), but analysis of the same time period will likely not (closer to my results).
.
Clearly factor analysis is not exactly a precision instrument, and I think the "factor exposure and expense ratios are all that matters" argument is incomplete. At the very least, it should be combined with other asset allocation considerations and some common sense metrics (more diversification is better than less, simple fund screens and momentum mangement is preferable to forced trading and arbitrary reconstitution dates, and so on...)

Do I think DFA value funds should load the same or similar on the value factor as a mid value or small value index? Possibly. When you exclude any stock larger than $7B (as mid value does), you certainly increase value exposure irrespective of the % sort. And the big slug of REITS that most small value index funds hold certainly increase the perceived value loading.

A better question is: do you think a $3B market cap mid value index and a $35B market cap marketwide value fund should have almost identical size loadings? Of course not, probably a model misspecification which translates into more index portfolio risk (due to much smaller stock sizes) than simple factor coefficients would indicate.

But everyone should use the process they are most comfortable with. I don't have much else to add.
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Post by peter71 »

Hi Robert, Hi Fixer,

IIRC Robert is doing OLS regressions and apparently Fixer is doing a factor analysis. Do either of you recall where in the literature you've seen either of these two techniques advocaed for use in this context -- basically, if I understand your purposes, determining how small or how valuey a given fund has been over time?

All best,
Pete
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Post by Robert T »

.
the fixer wrote:Clearly factor analysis is not exactly a precision instrument, and I think the "factor exposure and expense ratios are all that matters" argument is incomplete. At the very least, it should be combined with other asset allocation considerations and some common sense metrics (more diversification is better than less, simple fund screens and momentum mangement is preferable to forced trading and arbitrary reconstitution dates, and so on...)
Personally, I think that the impact of all the factors you listed show up in alpha and R^2 differences in the FF three factor regressions (“the factor exposure’ part of Bernstein’s quote). e.g. as with the S&P pure value on less diversification, and the Russell 2000 value on forced trading. I agree the factor analysis is not an exact science but it stands up remarkably well. Obviously important to look at other factors as well, but IMO as complements, not substitutes, to fund selection decisions. Just personal preference.
Do I think DFA value funds should load the same or similar on the value factor as a mid value or small value index? Possibly. When you exclude any stock larger than $7B (as mid value does), you certainly increase value exposure irrespective of the % sort. And the big slug of REITS that most small value index funds hold certainly increase the perceived value loading.
Yes – small cap exposure does tend to increase value exposure. But you had US targeted value and the S&P600 value series with almost the same size and value loads (0.6 vs 0.65, and 0.54 vs. 0.60), despite the 30% vs 50% value sort difference. Just reiterates to me the importance of using the same/similar time period estimated factor loads when matching portfolios to compare relative portfolio performance.
A better question is: do you think a $3B market cap mid value index and a $35B market cap marketwide value fund should have almost identical size loadings? Of course not, probably a model misspecification which translates into more index portfolio risk (due to much smaller stock sizes) than simple factor coefficients would indicate.
Or put another way – do you believe the size premium is non-linear, dominated by Decile 1 and 10? Maybe yes (at least to the former, as I recall). Tax-managed US equity has a market cap of $65bn, so DFA marketwide value is much smaller at $35bn, perhaps avoiding decile 1 (or with low weighting to decile 1). So the earlier factor loading similarities may just reflect this non-linearity.
But everyone should use the process they are most comfortable with. I don't have much else to add.
I agree (thank you Eugene Fama and Ken French). Time will tell.

--------------------

peter71,

Both using OLS - as did Fama-French 1993. Despite all the criticisms (collinearity, simultaneity biases etc) it stands up fairly well. FF take a simple approach and split time periods using OLS for both then compare (at least in several of their papers). No doubt many more sophisticated techniques (re: time varying parameters), but not sure they would add much.

That’s about it from me. Happy Thanksgiving.
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Post by the fixer »

I thought this would be a fairly interesting exercise, as it may help to address some of the questions/concerns/doubts regarding what to expect from the DFA approach and how they design their indexes relative to an identical (from a factor exposure standpoint) ETF/ retail index fund portfolio. It also appears to be a little more realistic as it actually uses portfolio combinations that seem to be believable/coherent from an investability standpoint.

Lets use two examples: the first will consist of the DFA US Core 2 Index, the Int'l Core Index, and DFA Emerging Market Index and the identical ETF factor portfolio. The second will consist of DFA US Vector Index, Int'l Vector Index, and and DFA Emerging Market Index and the identical ETF factor portfolio.

For comparison purposes in each region, we will go back as far as data is available for index fund data (1986 for US to include Midcap Value, 1999 for Int'l to include EAFE Small Cap, and 1988 for Int'l as both MSCI EM and DFA EM Indexes start this year) so that there is no time mismatch and to benefit from the longest time available (not starting everything from the latest date the newest index is available--which is only 1999). Furthermore, EM stocks will not be tilted to reflect a lack of decent retail index options in this asset class.

A quick summary: the weighted average of the "DFA Core" portfolio, which is a very modest small cap value tilted allocation, outperformed the weighted average of the identical "DFA Core mimicing" ETF allocation by 1% per year. The weighted average of the "DFA Vector" portfolio, which is more of a moderate small cap value tilted allocation, outperformed the weighted average of the identical "DFA Vector mimicing" ETF allocation by 1.5% per year.

The DFA Core portfolio was 50% US Core 2 Index, 37.5% Int'l Core Index, and 12.5% DFA Emerging Markets Index. The ETF mimicing allocation was 25% Russell 3000, 12.5% Russell Mid Value, and 12.5% CRSP 10, 7.5% EAFE, 15% EAFE Value, 15% EAFE Small Cap, and 12.5% MSCI EM Index.

The DFA Vector portfolio was 50% US Vector Index, 37.5% Int'l Vector Index, and 12.5% DFA Emerging Markets Index. The ETF mimicing allocation was 5% Russell 3000, 22.5% Russell Mid Value, and 22.5% CRSP 10, 15% EAFE Value, 22.5% EAFE Small Cap, and 12.5% MSCI EM Index.

Clearly, there is no right or wrong way to do this. When you factor in the higher real world costs of rebalancing between component ETF funds (taxes, spreads, etc.) vs. and integrated Core allocation, it is not unrealistic to subtract another .25% to .5% per year from the ETF mix. Furthermore, as we know, if you dialed up these exposures using a Large Value and Small Value index (S&P 500 Value and 600 Value or Russell 1000 Value or 2000 Value) instead of mid cap, or used a combination Total Stock Index/Small Value portfolio instead of TSM, Mid Value, Micro, you could have cost yourself another 1% or so per year.

As I said before, factor analysis and benchmarking is an inexact approach, and some have more confidence in it that others (and I say good for them!). But is a 1% to 2% DFA advantage unheard of or outside the bounds of what is possible? Hopefully the simple example above would illustrate that it is not. Is it possible to find an inferior DFA allocation whose returns can be achieved through ETFs? I guess that is possible as well, especially as you reduce your tilt away from the market.

Happy Thanksgiving!
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Post by peter71 »

Robert T wrote:.
the fixer wrote:Clearly factor analysis is not exactly a precision instrument, and I think the "factor exposure and expense ratios are all that matters" argument is incomplete. At the very least, it should be combined with other asset allocation considerations and some common sense metrics (more diversification is better than less, simple fund screens and momentum mangement is preferable to forced trading and arbitrary reconstitution dates, and so on...)
Personally, I think that the impact of all the factors you listed show up in alpha and R^2 differences in the FF three factor regressions (“the factor exposure’ part of Bernstein’s quote). e.g. as with the S&P pure value on less diversification, and the Russell 2000 value on forced trading. I agree the factor analysis is not an exact science but it stands up remarkably well. Obviously important to look at other factors as well, but IMO as complements, not substitutes, to fund selection decisions. Just personal preference.
Do I think DFA value funds should load the same or similar on the value factor as a mid value or small value index? Possibly. When you exclude any stock larger than $7B (as mid value does), you certainly increase value exposure irrespective of the % sort. And the big slug of REITS that most small value index funds hold certainly increase the perceived value loading.
Yes – small cap exposure does tend to increase value exposure. But you had US targeted value and the S&P600 value series with almost the same size and value loads (0.6 vs 0.65, and 0.54 vs. 0.60), despite the 30% vs 50% value sort difference. Just reiterates to me the importance of using the same/similar time period estimated factor loads when matching portfolios to compare relative portfolio performance.
A better question is: do you think a $3B market cap mid value index and a $35B market cap marketwide value fund should have almost identical size loadings? Of course not, probably a model misspecification which translates into more index portfolio risk (due to much smaller stock sizes) than simple factor coefficients would indicate.
Or put another way – do you believe the size premium is non-linear, dominated by Decile 1 and 10? Maybe yes (at least to the former, as I recall). Tax-managed US equity has a market cap of $65bn, so DFA marketwide value is much smaller at $35bn, perhaps avoiding decile 1 (or with low weighting to decile 1). So the earlier factor loading similarities may just reflect this non-linearity.
But everyone should use the process they are most comfortable with. I don't have much else to add.
I agree (thank you Eugene Fama and Ken French). Time will tell.

--------------------

peter71,

Both using OLS - as did Fama-French 1993. Despite all the criticisms (collinearity, simultaneity biases etc) it stands up fairly well. FF take a simple approach and split time periods using OLS for both then compare (at least in several of their papers). No doubt many more sophisticated techniques (re: time varying parameters), but not sure they would add much.

That’s about it from me. Happy Thanksgiving.
.
Hi Robert,

I'm off for Thanksgiving too and I agree with you that collinearity in particular shouldn't be a big deal given a reasonable sample size, but I'll have to look into exactly what Fama-French '93 were up to in using OLS (i.e., making alpha go away in a causal model vs. measuring the smallness and valueyness of funds). . . If Fixer is also using OLS then it must just be the time periods that gives you different results, but as you probably know there is also something called "factor analysis" that's often associated with measurement models so if that is actually what he's using you could argue that's more appropriate to the task at hand (though, at least in theory, my preference remains to simply "observe" the smallness and valueyness of the stocks over time).

http://en.wikipedia.org/wiki/Factor_analysis

All best,
Pete
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Post by peter71 »

dup post deleted.
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Post by Robert T »

.
the fixer wrote:what to expect from the DFA approach and how they design their indexes relative to an identical (from a factor exposure standpoint) ETF/ retail index fund portfolio
I would simply say to investors – do your own analysis. Make your own comparisons. Don’t rely much on secondary results (time periods vary, indexes vary, agency issues vary etc). I simply don't get the 1 to 2% perpetual DFA out-performance often reported on this forum (as in the earlier comparisons in this thread). But again, do your own analysis. Draw your own conclusions.

Personally I would expect small differences in factor mimicking (exact/identical) ETF and DFA portfolios, with zero alpha’s and high R^2s (in the FF3F regressions), by the mere fact this almost becomes a mathematical identity. No additional explanations required (seems to be confirmed by the earlier reported factor load analysis).

[1* (Rm-RF) + 0.2* SmL + 0.4 HmL] = [1*(Rm-Rf) + 0.2*SmL + 0.4 HmL]

So for ETFs, the implication seems to be select those with closest to zero alphas and highest R^2. There are certainly indexes that don’t match these characteristics, or score more poorly than others e.g. so far, Russell 2000 value vs. S&P600 value and MSCI small value, or Russell midcap value vs. MSCI midcap value, where differences in alpha show up in differences in return performance. But IMO, the indexes with significant alphas fail the test of pure factor exposure. And there are enough ETFs which pass the test to develop a reasonably close factor mimicking portfolio (not the perpetual 1 to 2% difference often reported … [see identity above]).

On real world costs of implementation (taxes, spreads etc…). Arguably ETFs have higher tax efficiency, and a significant share of rebalancing will be between regions, on which the core/vector portfolios would not benefit. Personally, I think I would still favor a DFA TM component portfolio over a core/vector portfolio to minimize tax impacts (i.e. maximize after tax returns for a given factor exposure). Yes there may be some efficiency gains in the core/vector approach but do not think they are as large as they are often made out to be. Time will tell.

Again, there may be many other credible reasons to own DFA funds, but don't think one of them is an expectation of 1 to 2% outperformance (alpha) above factor exposure. Just my take. Obviously opinions differ.

Nothing much more to add.

-------------------------------

Pete,

Have never much liked the principal component type analysis (often difficult to interpret results, and their implication). Seems most applicable in marketing (rather than finance) type analyses.

Robert
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Post by Random Musings »

With respect to EM (of course what country is considered an EM is another question altogether).

With higher volatility expected, would rebalancing by buying low and selling high make that asset class a decent diversifier to a portfolio?

RM
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Post by Rodc »

Random Musings wrote:With respect to EM (of course what country is considered an EM is another question altogether).

With higher volatility expected, would rebalancing by buying low and selling high make that asset class a decent diversifier to a portfolio?

RM
Add the condition that it is largely uncorrelated (or just low correlation) to the rest of your portfolio and the answer may be yes. Add decent positive long term returns and the answer is almost certainly yes.

That is a longish list of conditions.

(I hold EM, but not a ton)
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Post by Kenster1 »

With Emerging Markets up about 80% over the past 1 year and Emerging Markets Smallcap (SPDRS EM Smallcap ETF) up about 101% over the past 1 year ---- could be time not to get too greedy and take some profits off the table.
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Post by the fixer »

Factor analysis certainly can help tell you if or how an index or fund has captured the market, small cap, and value premiums, but it leaves out many real world considerations important in day to day investing. Here are a few that can tilt the advantage in favor of certain DFA allocations such as the Vector portfolios that I mentioned above (relative to factor matched ETF or index fund strategies) assuming reasonable assumptions:

1. There tends to be far lower turnover that can account for lower internal costs. For example, in 2008, the US Vector fund had about 10% portfolio turnover, whereas the Vanguard Mid Value Index and Bridgeway Ultra Small Funds ranged from 30% to 70%. With 2-4 times less internal turnover, and the trading that does take place in Vectors more in the mid/large cap segment of the market, its plain to see that DFAs approach could amount to +.1% to +.25%.

2. On top of this, there is no necessary rebalancing between large and small or growth and value stocks within each region. While much portfolio rebalancing does occur from stocks to bonds or US to non-US, different regional dimensions will also drift over time. Its reasonable to assume no inter-regional rebalancing could add another +0.1% to +0.25% over time.

3. Many index funds like Vanguard Mid Value or iShares Russell Mid Value or S&P 600 Value and passive funds like Bridgeway Ultra Small have very limited securities lending programs that can detract from returns. In the last 12 months, DFA US Vector has offset its entire expense ratio (0.34%) by securities lending, where Vanguard Mid Value ETF has only earned 0.1%. Depending on the asset class, DFAs more active securities lending program may add +0.1% to +0.3% over time.

4. Traditional index funds are less focused on capturing each dimension of the market and more concerned with arbitrary index definitions designed simply to slice the market inclusive of every non-micro cap stock. The result is that regulated utilities and REITs are admitted into small cap and value funds when they don’t truly act or perform as their factor exposure would assume. Historically, regulated utilities have had a beta of only about 0.65, sacrificing almost 2% of the possible equity premium. Similarly, REITs have underperformed small value stocks by over 4% per year since the 70s, and about 2.5% per year relative to the Vector index. With anywhere from 10% to 20% of style based index funds containing utilities and REITs, its possible their drag on returns can amount to +0.25% to +0.5% per year.

5. In more remote areas of the market like microcap stocks, ETFs and true index funds are notoriously inefficient at navigating the unavoidable illiquidity, and passive funds like Bridgeway Ultra Small Market have also had their challenges. Since inception in 1997, BRSIX has trailed CRSP 10 by over 1% per year with 20% to 50% yearly tracking error. Its unclear whether or not the simulated returns of deep, tiny micro cap securities necessary to deliver strong small cap tilts to index portfolios are achievable. Its possible that +0.25% to +0.5% of index portfolio returns could be sacrificed due to an inability to actually deliver concentrated, remote regions of the market like micro cap.

6. While experts vary on their opinion regarding the magnitude and persistence of momentum in securities prices, index funds tend to reconstitute arbitrarily and avoid any recognition of the impact of positive and negative momentum on stock prices. Since the mid 80s, a Mid Value/CRSP 10 portfolio has had almost -0.20 coefficient with momentum, and is highly significant. DFA has incorporated a rigorous patient trading process that is designed to avoid the harmful impact of negative trading costs, and in the 4 years since inception, the live US Vector fund has only had -0.03 exposure to momentum, which is statistically insignificant and not reliably different from 0. To the extent that historical momentum returns persist (6% to 8% per year), this could cost a portfolio +1% to +1.5% per year in lost returns.

7. Also, as it relates to index reconstitution, it tends to be the case that index portfolios offer less consistent exposure to their risk factor or asset class throughout the year. Indexes tend to have higher exposure to their dimension during summer months when reconstitution takes place, with less sensitivity during winter and spring months when the premiums have historically been more robust. A quick view since ’86 of Mid Value and CRSP 10 factor exposures during August to November (when loadings are much higher but premiums are negative) compared to the factor returns from December through July (when loadings are lower but premiums are positive and statistically significant) reveals that a more consistent/uniform exposure to the dimensions of small and value would have added +0.3% to +0.5% higher returns. DFAs process, instead, uses periodic cashflows to rebalance, and this results in their funds having more consistent factor exposure throughout the year, especially important during winter/spring months when premiums have been seasonally higher. Since ’86, the US Vector index has actually had a slightly higher exposure to value (HmL) during Dec-July (+0.43) months than Aug-Nov (+0.38 ). During the former months, HmL averaged +5% annually, vs. only +0.6% during the later months.

Whether you believe any of these advantages will persist going forward, that’s for you to decide. If you think my cautious estimates are realistic (the first number), then the advantage for DFA is about +1.9%. If you think my higher estimates are more probable (the second number), then the number balloons to over 3% per year. One thing is clear, however: factor sensitivities by themselves do not tell the whole story of investment returns. And based on some of the procedures and common sense applications that DFA has incorporated into their fund management, its not entirely unthinkable that they can add 1% to 2% in returns above a factor adjusted ETF portfolio. Do you need DFA funds to reach your goals? Of course not. Is there value there? You be the judge

Other qualitative benefits that may or may not be attractive to investors include:
• the psychological benefit of consistent regional (US, non-US) small cap and value exposure instead of unbalanced tilts (ETF portfolios are often forced to employ heavier small/value exposure in the US market based on better style options, where investors are more tracking error sensitive). Furthermore, for investors who want the added diversification benefits of a stronger non-US tilt to small and value without the associated tracking error issues (most investors aren’t as concerned with their international stock performance relative to the EAFE), that option is also much easier accomplished with DFA, for example, by combining Int'l Vector with Int'l Small Value

• not having to hold as many extreme, remote component index fund strategies (ie. micro cap or small value) that tend to have very divergent performance from TSM or the S&P 500 relative to a more evenly distributed Vector equity portfolio that gains size exposure from a large cap/growth underweight as well as a mid/small/micro/value overweight. Emotionally, this can be easier to tolerate during periods where small cap and value dimensions are not generating added returns

• targeting each added dimension as fully as possible with minimal security overlap. Using a Mid Value fund to tilt to value stocks uses about 250 securities. In the US Vector fund, it holds 1800 distinct value stocks across large/medium/small/and micro categories—effectively every stock with a low price to book ratio excluding REITs and Utilities. Using a micro cap fund like Bridgeway Ultra Small Market to target the small cap premium contains about 500 securities. The US Vector fund, on the other hand, holds over 3,000 distinct non-large cap stocks, while significantly underweighting (relative to the market) the largest mega cap securities where liquidity is highest and expected returns are lowest. Broader and more complete exposure to added risk dimensions increases the likelihood and consistency of delivering the premium without wondering if a give return premium will show up in your “corner” of the market chosen to target a broad risk dimension (ie. Mid Value or tiny Micro Cap stocks)

Just one way to look at it. My final thoughts.
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Post by Robert T »

.
the fixer wrote:Factor analysis certainly can help tell you if or how an index or fund has captured the market, small cap, and value premiums, but it leaves out many real world considerations important in day to day investing. Here are a few that can tilt the advantage in favor of certain DFA allocations such as the Vector portfolios that I mentioned above (relative to factor matched ETF or index fund strategies) assuming reasonable assumptions:
Here are some views on each, including the extent the listed factors are excluded from a factor load analysis.

Turnover: (i) internal costs (a) brokerage commissions: my earlier look at this was that the brokerage commissions of the DFA vector fund were 50 percent larger than the iShares S&P600 index. Both had a turnover of 14% last year. The reason IMO: it takes more transactions to get the 14% turnover with the US Vector fund (3,300+stocks), than with an index like the S&P600 with about 600 stocks, (b) bid-ask spread: DFAs patient trading could reduce bid-ask spreads relative to the less patient trading of index type funds. However, Bridgeway also uses patient trading (and has a primary focus on reducing trade costs), the S&P600 screening approach reduced less liquid stocks thereby likely reducing bid-ask spread costs, and these spreads are fairly narrow when getting up to mid-cap stocks. (ii) tax costs – the ETF structure benefits from the internal creation and redemptions process which should add to tax efficiency. The low turnover (10% or so) of the open-ended vector type fund should add to tax efficiency, but its future expected tax efficiency is unclear IMO. The DFA US large value portfolio, for example, seems to have roughly similar turnover, yet its 10-year tax-cost has been 1.3 percent of returns.

Internal rebalancing: Much of the stock migration (turnover) seems to occur from value to netural (SV to SN) [re: the FF migration paper]. From 1926-2005, on average 17% of SV stocks moved annually from SV to SN and SG (also about 17% of market cap), while 3% of stocks moved from SV to LV (about 8% of market cap). As the MSCI and S&P value funds cover much of the SV-SN spectrum (at least more so than the DFA component value funds), they already include some migration benefit. Coupled with the ETF structure, and reduced brokerage commissions, I don’t think internal rebalancing trade costs and tax impacts will be dramatically different from a Vector type open ended fund approach (and I think there is some double counting between turnover and internal rebalancing).

Securities lending: DFA has a larger program than Vanguard, iShares or Bridgeway. However, securities lending is not a risk-free exercise (see Swensen’s book), so maybe larger but no free-lunch IMO.

Utilities and REITS: Several/many concentrated sector portfolios don’t seem to perform as their factor exposure would suggest i.e. low R^2 (as in the FF Industry Cost of Equity paper) – perhaps a reflection of idiosyncratic industry risk. Some blue chips also have low beta, so I don't think REITs are unique in this respect. Excluding REITs may raise portfolio beta (in the FF3F regressions) to above 1 percent, as with many of the DFA funds. But any resulting added return is from higher risk (not alpha).

Liquidity: I think Bridgeway does as good a job as any in navigating illiquidity in the micro-cap space. And if you believe the size premium can be captured by underweigthing CRSP1 relative to all other deciles then this is much less of an issue and don’t see much of a DFA vector liquidity benefit.

Momentum: Here is an earlier analysis, using very similar analysis time periods, which suggests that DFA funds have historically had a larger negative momentum load than many/most of the retail index funds (likely from more frequent rebalancing/reconstitution relative to annual rebalancing). Will the future performance be different? Not sure.

Seasonal factor premiums and index reconstitution frequency: Estimates of annual average factor loads include any seasonal effects. i.e. the annual value premium = 4%, a fund value load of 0.4 indicates the fund captured 1.6% of this premium (4*0.4). The only way to capture more of this value premium is to have a higher annual value load (e.g. 0.45). i.e. you can’t capture more of the annual premium, by having more value exposure in Dec-July and less in Aug-Nov. while maintaining a 0.4 estimated average value load, the higher exposure when premiums are high will show up in a higher value load (that’s how the OLS regressions work – as I understand them).

Adding up: Following the above, in my view the utilities/REITs, momentum, and reconstitution frequency show up in factor exposure estimates. Momentum has some negative alpha effects. So we are left with turnover & internal rebalancing effects, securities lending and liquidity effects which, following the above, I don’t think will result in the 1 to 2 to 3%(!) alpha. Just my take.

Now I agree on some of the other reasons often listed to hold DFA funds: e.g. simplicity, ability to take more even factor exposure across US:EAFE:EM, if want large/'extreme' value loads, and a fund company with product lines (and ongoing research) linked to a common (Fama-French) framework (all of which I think are credible reasons), but not the 1 to 2 (to 3)% in alpha above factor exposure. Again just my take.

Robert
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jeffyscott
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Post by jeffyscott »

Markets are efficient, yet DFA is able to (theoretically) outperform by 2-3%? :confused

Seems like that level of superiority should be easily detectable in their actual returns, has it been? The one DFA fund I happen to own, DFSCX, certainly appears not to have demonstrated anything like this over the last 5 years (M* has it ranked in the bottom 25% of it's category).
ScottW
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Post by ScottW »

the fixer wrote:3. Many index funds like Vanguard Mid Value or iShares Russell Mid Value or S&P 600 Value and passive funds like Bridgeway Ultra Small have very limited securities lending programs that can detract from returns. In the last 12 months, DFA US Vector has offset its entire expense ratio (0.34%) by securities lending, where Vanguard Mid Value ETF has only earned 0.1%. Depending on the asset class, DFAs more active securities lending program may add +0.1% to +0.3% over time.
I'm not sure where these numbers are coming from. Bridgeway's fund has been very aggressive at lending, and looking at this year's annual report, their lending revenue for the year ending 6/30/09 ($3.7 mil) exceeded the fund's expenses ($3.1 mil).

While I agree that Vanguard does not generate as much lending revenue, their expenses (particularly their ETFs) are lower, which means they don't have to be as aggressive. You mentioned that the Mid Value ETF only generated 0.1% of revenue last year, but when the expense ratio is only 0.15%, that's not too bad. The DFA numbers may be larger, but they need to be to offset their higher expense ratios.
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