Why does small cap value outperform?

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kjm
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Why does small cap value outperform?

Post by kjm »

I guess I'm asking two questions really. Why do small cap stocks outperform mid and large cap stocks? And why do value stocks outperform growth stocks?

If I had to take a stab, I'd say small stocks and value stocks are riskier. The extra return return is compensation for the risk.

What do you guys think?
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Post by White Coat Investor »

You are mostly correct. More risk equals more EXPECTED performance. Smaller companies, and value companies (i.e. not the leaders in their field) are less well-capitalized and more likely to disappear or do poorly in a tough economic environment, so they're more risky. Investors should demand more compensation for taking that risk.
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Post by ObliviousInvestor »

Yep, you hit it right on. Value stocks and small-cap stocks carry a higher level of risk and therefore a higher level of expected returns.

(And perhaps I'm strange, but I find it fascinating to note that in the case of value stocks, "risk" is not necessarily equated to volatility, like it so often is.)
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SP-diceman
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Post by SP-diceman »

Its easier to have growth when you are a small company.
Imagine you have 1 million in sales.
Generate a million more and you've doubled.
Now imagine you have 10 billion in sales.
You need to generate 10 billion to double.

Aside from the growth/size metric you also have value.
(for some reason the stock is selling at a discount)

So you have two metrics in your favor size /value.

Typically small cap is considered riskier because
of its inability to handle adversity.
(who gets hurt more in an economic downturn a billionaire
or a guy who makes 30K a year?)

All things being equal I actually consider growth riskier.
Since its one metric and not necessarily guaranteed.
If you are buying value then it already has value and
doesn't have to do much. A simple revision to the mean
should lead to higher prices.
(growth also tends to be factored in while the value
stock actually has value)


Thanks
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madsinger
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Re: Why does small cap value outpreform?

Post by madsinger »

kjm wrote:What do you guys think?
I suspect the "accepted answer" on this board has to do with risk. Personally, I think it is more a behavioral issue. Ask "investors" which company they'd rather invest in...Google or International Paper? Amazon or Goodyear tire? A great big "safe" company like WalMart, or a small retailer you've probably never heard of?

I think investors pay a P/E, P/B, P/S "premium" for large and "hot" companies. Now, there are often "good reasons" for investing in some "obvious winners" like Google, or avoiding some "obvious losers" like GM. But, I think (no research here, just observations) many investors are not really making cool-headed decisions about "risk and reward", but rather, are making "gut-decisions" on which company they think is "better".

FWIW, I overweight small and value in my portfolio because I think those are the regions of the market that are not "overbought", and therefore, less likely to be overpriced.

-Brad.
kenner
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Re: Why does small cap value outpreform?

Post by kenner »

kjm wrote:I guess I'm asking two questions really. Why do small cap stocks outperform mid and large cap stocks? And why do value stocks outperform growth stocks?

If I had to take a stab, I'd say small stocks and value stocks are riskier. The extra return return is compensation for the risk.

What do you guys think?
Vanguard stock index funds, average annual return, last ten years (as of 8/31/09):

Mid-Cap Index 6.19%
Small-Cap Index 5.06%
500 Index -0.86%
Small-Cap Growth 5.89%
Small-Cap Value 6.81%

Past returns have no bearing on future returns, especially over short investment time horizons.

Risk is ultimately related to return on investment.

From the noted financial writer and Boglehead friend, Dr. Bill Bernstein:

"This is an essential point that escapes most small investors. Even the world’s most sophisticated financial economists occasionally make this mistake: in financial academese, they "conflate expected returns with realized returns." Or in plain English, they confuse the future with the past. This point cannot be made forcefully enough or often enough: high previous returns usually presage low future returns, and low past returns usually mean high future returns.

The rub here is that buying when prices are low is always a very scary proposition. The low prices that produce high future returns are not possible without catastrophe and risk. The moral for modern investors is obvious: the recent very high stock returns in the U.S. would not have been possible without the chaos of the nineteenth century and the prolonged fall in prices that occurred in the wake of the Great Depression. Conversely, the placid economic, political, and social environment before the World Trade Center bombing resulted in very high stock prices; the disappearance of this apparent low-risk world produced low returns in its wake.



CHAPTER SUMMARY

1. The history of the stock and bond markets shows that risk and reward are inextricably intertwined. Do not expect high returns without high risk. Do not expect safety without correspondingly low returns. Further, when the political and economic outlook is the brightest, returns are the lowest. It is when things look the darkest that returns are the highest.

2. The longer a risky asset is held, the less the chance of a loss.

3. Be especially wary of data demonstrating the superior long-term performance of U.S. stocks. For most of its history, the U.S. was a very risky place to invest, and its high investment returns reflect that. Now that the U.S. seems to be more of a "sure thing," prices have risen, and future investment returns will of necessity be lower."
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Re: Why does small cap value outpreform?

Post by yobria »

kjm wrote:If I had to take a stab, I'd say small stocks and value stocks are riskier. The extra return return is compensation for the risk.
That's easy to test, just compare yields on the debt of small and value stocks and see if they're higher than the market as a whole. If not, the market thinks they're no riskier than other segments.

Nick
MrMatt2532
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Post by MrMatt2532 »

ObliviousInvestor wrote:(And perhaps I'm strange, but I find it fascinating to note that in the case of value stocks, "risk" is not necessarily equated to volatility, like it so often is.)
I'd be careful here. Sometimes there is a myth perpetuated that value stocks have less volatility than blend or growth. If you look at the long term data though, you will see that value stocks do indeed have greater volatility.
kenner
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Post by kenner »

MrMatt2532 wrote:
ObliviousInvestor wrote:(And perhaps I'm strange, but I find it fascinating to note that in the case of value stocks, "risk" is not necessarily equated to volatility, like it so often is.)
I'd be careful here. Sometimes there is a myth perpetuated that value stocks have less volatility than blend or growth. If you look at the long term data though, you will see that value stocks do indeed have greater volatility.
Interesting. Risk and volatility are two distinct concepts.

From "The Oblivious Investor" website:

http://www.obliviousinvestor.com/2008/1 ... -the-same/
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Post by Trev H »

MrMatt...

==
Sometimes there is a myth perpetuated that value stocks have less volatility than blend or growth. If you look at the long term data though, you will see that value stocks do indeed have greater volatility.
==

You have to go back to the Great Depression to see the period where value showed more risk "based on volatility".

Could be that we never see that again - - - just look at what happened last year or two, and so far this year. Could say things have improved quite a bit as far as how depressions/recessions are dealt with.

It is also true that the Slice/Dice investor going as far as 50/50 Large Market / Small Value (since 1970 - rebalanced yearly) have had much better risk adjusted (Sharpe Ratio) returns, and lower Volatility - than the Lumper/TSM investor.

IMO - TSM is the most risky way to hold US Equities.

If you look at all of the 10 year rolling periods (since 1970 or 1929) Lumping everyhing into TSM = very risky.

LB/SV = much better bet even at 50/50 weightings.

It simply pays to diversify.

TSM is nothing but an illusion of diversification. You might as well hold nothing but US Large Market.

=====
grok87
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Re: Why does small cap value outpreform?

Post by grok87 »

yobria wrote:
kjm wrote:If I had to take a stab, I'd say small stocks and value stocks are riskier. The extra return return is compensation for the risk.
That's easy to test, just compare yields on the debt of small and value stocks and see if they're higher than the market as a whole. If not, the market thinks they're no riskier than other segments.

Nick
+1
That's a good way to think about it. We can observe bond yield risk premiums much more easily than equity risk premiums. To get bond yield risk premiums you start with the spread over treasuries and maybe make small adjustments for liquidity and embedded call options etc

By contrast the equity risk premium for a stock is a lot trickier to calculate.

Take McDonalds from the S&P 500 and Pep Boys from the small cap value index. McDonalds bonds trade at a yield spread of under 100 bps (80 bps last time I checked). Pep Boy's trades at a spread of 700 bps or so.

The cost of equity capital (= expected equity returns) is by definition greater than the cost of debt capital (since equity claims are subordinate to debt claims). So the expected equity risk premium for Pep Boys is much greater than that for McDonalds. Now you don't always get to collect the equity risk premium- sometimes risk shows up.

cheers,
RIP Mr. Bogle.
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Post by MrMatt2532 »

Trev, I'm right there with you about diversifying across size and value. I just don't want to give people the idea that holding value gives less volatility and more reward if this is not the case.

By the way, here is the Fama/French Benchmark portfolio data:

Code: Select all

1927-2008						
	   B/L 	 B/M	  B/H	  S/L	  S/M	  S/H
avg	10.93	12.02	14.54	13.69	16.38	18.34
std	20.74	21.64	27.89	33.47	29.47	32.55

1970-2008						
	   B/L 	 B/M	  B/H	  S/L	  S/M	  S/H
avg	10.38	12.06	12.97	10.41	15.04	17.00
std	19.69	17.44	20.55	27.36	22.25	25.35

1990-2008						
	   B/L 	 B/M	  B/H	  S/L	  S/M	  S/H
avg	9.65	 9.89	 8.22	 8.71	 12.75	13.66
std	21.22	17.80	22.68	27.06	21.45	28.14


B=Big, S=Small, H=Value, M=Neutral, G=Growth
Looking at large value compared to blend and growth, there was more volatility over the longer period and more volatility over the last twenty and forty years as well.

I understand vanguard fund returns may look a little different in terms of risk and reward, but this is probably because they don't target value to the extent that the fama/french portfolios do.
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Re: Why does small cap value outpreform?

Post by peter71 »

grok87 wrote:
yobria wrote:
kjm wrote:If I had to take a stab, I'd say small stocks and value stocks are riskier. The extra return return is compensation for the risk.
That's easy to test, just compare yields on the debt of small and value stocks and see if they're higher than the market as a whole. If not, the market thinks they're no riskier than other segments.

Nick
+1
That's a good way to think about it. We can observe bond yield risk premiums much more easily than equity risk premiums. To get bond yield risk premiums you start with the spread over treasuries and maybe make small adjustments for liquidity and embedded call options etc

By contrast the equity risk premium for a stock is a lot trickier to calculate.

Take McDonalds from the S&P 500 and Pep Boys from the small cap value index. McDonalds bonds trade at a yield spread of under 100 bps (80 bps last time I checked). Pep Boy's trades at a spread of 700 bps or so.

The cost of equity capital (= expected equity returns) is by definition greater than the cost of debt capital (since equity claims are subordinate to debt claims). So the expected equity risk premium for Pep Boys is much greater than that for McDonalds. Now you don't always get to collect the equity risk premium- sometimes risk shows up.

cheers,
Hmm, but is McDonalds even a "growth" company and does anyone know the AVERAGE difference in spreads between SV and LG? I agree that these bond spreads are a good way to operationalize default risk, and, by extension, perhaps also the risk of equity going to zero, but a) I'd be surprised if the typical regional SV utility company has to pay big when it issues a bond and b) I believe I've seen some academic work on how default risk and other types of risk that equity investors might plausibly care about often diverge (some NYU conference a couple years ago in particular) . . . so at this point I'm personally more inclined to give my +1 to madsinger and the behavioral explanation. :D

All best,
Pete
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Post by eurowizard »

ObliviousInvestor wrote:"risk" is not necessarily equated to volatility, like it so often is.)
That's interesting how you take a mathematical concept such as "risk" which is based on the mathematical variance and choose to redefine it contrary to the way that experts have chosen to use it.

In the business world, risk = variance which increases proportionally to volatility according to the mathematical definition.

I suppose you could choose to redefine the word "up" to mean "down" as well if you like. Personally, I'll stick with the econometric definition of "risk."
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Post by ObliviousInvestor »

eurowizard wrote:
ObliviousInvestor wrote:"risk" is not necessarily equated to volatility, like it so often is.)
That's interesting how you take a mathematical concept such as "risk" which is based on the mathematical variance and choose to redefine it contrary to the way that experts have chosen to use it.
Sorry. I wasn't very thorough with my earlier comment.

I'm not trying to redefine it. I'm simply pointing out that the way academics/experts/the financial community defines "risk" is different from the way the typical investor defines "risk." The world of finance usually uses volatility as the measure of risk, if not downright equating the two. In other words, they (we?) roughly define risk as "chance that return < expected return." In contrast, if you ask most investors, they define risk as chance of loss, or "chance that return < 0."

I'm not trying to pass judgment on either definition. I'm just noting a difference in semantics that I find interesting and often significant.

Edit: Also, I've also read that some within the financial community don't find volatility to be the best measure of risk. From a section of Larry Swedroe's What Wall Street Doesn't Want You to Know titled "Are Value Stocks More Risky?":

"Those arguing that the market is efficient make the case that standard deviation, while a convenient measure, is not the only, or even necessarily the correct, measure of risk. Some focus on cost of capital as a better measure."

If I remember correctly, this concept also comes up in at several points in Peter Bernstein's Against the Gods, though I don't have the book on hand at the moment.
Last edited by ObliviousInvestor on Sun Sep 20, 2009 9:04 pm, edited 2 times in total.
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value, risk, and volatility.

Post by Random Walker »

Larry teaches this lesson often. standard deviation or variance is only one type of risk. Value stocks may well have less volatility and still be more risky if you include other types of risk. other types of risk might be the risk of doing really bad in a bad economy, being more leveraged, or something like that. Not all types of risk are encompassed by standard deviation. I expect that is why the correlation coefficients between HmL and beta and SmB and beta are significantly less than one and change over time.
I really like the way yobria views the issue. risk is proportional to cost of capital. Who would you rather lend money to from your own pocket: Microsoft or some new solar energy start up? Likewise, expected return should be proportional to cost of capital. If the returns on a value company are less volatile than other companies but the cost of capital is higher for the value company, then there is definitely some risk there; even if we can't give it a name or draw it on a graph.
I think though the value premium is not all a risk story. I think a small portion of it is behavioral as well. I think larry refers to this as a free stop at the dessert tray as opposed to a free lunch.
Lastly, I think it is really interesting how the hot big companies are viewed. Everyone wants to put money in these high PE companies because of expected tremendous growth. But by giving the companies a high PE, the market is really saying that the company is a fairly low risk bet and therefore expected future returns should be less. Unfortunately, when earnings dissapoint, these high PE growth companies get taken out and shot by the market.

Dave
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Post by speedbump101 »

"A companies cost of capital is the investors expected return. Small value companies therefore have higher expected returns than large growth companies. Long-term increases in expected return can only be achieved by accepting greater small cap and / or value risk."

http://www.tma-invest.com/files/Asset_class_funds.pdf

SB... Having heard Eugene Fama Jr. speak a while ago I can't forget his quote: "The cost of capital is the expected return." As a boy Merton Miller (family friend) 'bombarded' him with this phrase.
"Man is not a rational animal, he is a rationalizing animal" -Robert A. Heinlein
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Re: Why does small cap value outpreform?

Post by grok87 »

peter71 wrote:
Hmm, but is McDonalds even a "growth" company and does anyone know the AVERAGE difference in spreads between SV and LG?
Well I was picking McDonalds as a typical S&P 500 company, not necessarily large growth. The question as I see it is whether small value outperforms the market (in the long haul) and why. Arguably TSM is a better proxy for the market- but out of laziness myself and others tend to use the S&P 500 as "the market".
peter71 wrote:
b) I believe I've seen some academic work on how default risk and other types of risk that equity investors might plausibly care about often diverge (some NYU conference a couple years ago in particular) . . . so at this point I'm personally more inclined to give my +1 to madsinger and the behavioral explanation. :D

All best,
Pete
As with most things in life it's probably a bit of both (behavioral explanation and risk explanation probably both contribute).
Do you remember the name/date of that NYU conference? Sounds interesting- was Altman there?

cheers,
RIP Mr. Bogle.
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Re: Why does small cap value outpreform?

Post by yobria »

grok87 wrote:Take McDonalds from the S&P 500 and Pep Boys from the small cap value index. McDonalds bonds trade at a yield spread of under 100 bps (80 bps last time I checked). Pep Boy's trades at a spread of 700 bps or so.
Interesting, I bet small growth (the segment that has supposedly underperformed dramatically over the last 80 years) has yields similar to small value. If that's true what we might conclude is:

a) Small should outperform large going forward, value may not outperform growth

b) Historical patterns should be viewed with caution. Small growth has actually done quite well (relatively) over the past few years.

Nick
peter71
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Re: Why does small cap value outpreform?

Post by peter71 »

yobria wrote:
grok87 wrote:Take McDonalds from the S&P 500 and Pep Boys from the small cap value index. McDonalds bonds trade at a yield spread of under 100 bps (80 bps last time I checked). Pep Boy's trades at a spread of 700 bps or so.
Interesting, I bet small growth (the segment that has supposedly underperformed dramatically over the last 80 years) has yields similar to small value. If that's true what we might conclude is:

a) Small should outperform large going forward, value may not outperform growth

b) Historical patterns should be viewed with caution. Small growth has actually done quite well (relatively) over the past few years.

Nick
Hi Nick, Hi Grok,

I guess I don't care whether you test SV in general against TSM or LV but this all began with a claim that it's "easy" to do some sort of yield spread test along those lines, right? Now maybe it turns out that it's actually hard to test more than just a handful of companies' yield spreads -- esp. if this is a Bloomberg terminal thing -- but all I'm saying is that I don't think we can really answer Nick's easy question with reference to just a couple of companies.

All best,
Pete
grok87
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Re: Why does small cap value outpreform?

Post by grok87 »

peter71 wrote:
yobria wrote:
grok87 wrote:Take McDonalds from the S&P 500 and Pep Boys from the small cap value index. McDonalds bonds trade at a yield spread of under 100 bps (80 bps last time I checked). Pep Boy's trades at a spread of 700 bps or so.
Interesting, I bet small growth (the segment that has supposedly underperformed dramatically over the last 80 years) has yields similar to small value. If that's true what we might conclude is:

a) Small should outperform large going forward, value may not outperform growth

b) Historical patterns should be viewed with caution. Small growth has actually done quite well (relatively) over the past few years.

Nick
Hi Nick, Hi Grok,

I guess I don't care whether you test SV in general against TSM or LV but this all began with a claim that it's "easy" to do some sort of yield spread test along those lines, right? Now maybe it turns out that it's actually hard to test more than just a handful of companies' yield spreads -- esp. if this is a Bloomberg terminal thing -- but all I'm saying is that I don't think we can really answer Nick's easy question with reference to just a couple of companies.

All best,
Pete
nope it's not a bloomberg terminal thing but it does make it easier. You can get bond trades and yields here:
http://investinginbonds.com/
cheers,
RIP Mr. Bogle.
peter71
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Re: Why does small cap value outpreform?

Post by peter71 »

grok87 wrote:
peter71 wrote:
yobria wrote:
grok87 wrote:Take McDonalds from the S&P 500 and Pep Boys from the small cap value index. McDonalds bonds trade at a yield spread of under 100 bps (80 bps last time I checked). Pep Boy's trades at a spread of 700 bps or so.
Interesting, I bet small growth (the segment that has supposedly underperformed dramatically over the last 80 years) has yields similar to small value. If that's true what we might conclude is:

a) Small should outperform large going forward, value may not outperform growth

b) Historical patterns should be viewed with caution. Small growth has actually done quite well (relatively) over the past few years.

Nick
Hi Nick, Hi Grok,

I guess I don't care whether you test SV in general against TSM or LV but this all began with a claim that it's "easy" to do some sort of yield spread test along those lines, right? Now maybe it turns out that it's actually hard to test more than just a handful of companies' yield spreads -- esp. if this is a Bloomberg terminal thing -- but all I'm saying is that I don't think we can really answer Nick's easy question with reference to just a couple of companies.

All best,
Pete
nope it's not a bloomberg terminal thing but it does make it easier. You can get bond trades and yields here:
http://investinginbonds.com/
cheers,
Hey Grok,

Thanks, I'm certainly too lazy to do it but maybe Nick will get inspired!

All best,
Pete
bluejeansman
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Post by bluejeansman »

Interesting thread. I was going to ask that question myself but stumbled upon this post. I would like to say / ask a few things :

"Why does SCV outperform ? The extra return return is compensation for the risk. More risk equals more EXPECTED performance" - Sorry if I sound really dumb, but I just dont get this. Why should taking on more risk result in higher expected return ? I can understand risk being a *necessary* condition for higher expected reward, but it is not a *sufficient* condition, correct ? In other words, in logic, A ==> B (A implies B) where "A" is "high reward" and "B" is "high risk". That is, to get higher reward implies you would have taken on high risk. But this does not mean that B ==> A (B implies A), that is, taking on higher risk will automatically give your higher expected reward.

Another point : Didnt Jeremy Seigel say that 90+% of the stock market returns over the long run are due to dividends re-invested ? Large cap established companies are the ones that have good cash flow and pay our huge dividends, not small caps.

Wont the small cap value advantage be arbitraged away ? Investing in individual small cap or "value" companies may be risky and people may avoid it, but what is to prevent everyone to pile onto small cap and value index funds and then will we still continue to get the outperformance ?

Trev H : Are you saying TSM is not diversified ? I raised the same concern in http://www.bogleheads.org/forum/viewtop ... c&start=50 but there were some excellent replies to those. See the one by Tonen on Page 2 of that thread. I quote : "Another consequence of the EMH is that the total market is always perfectly diversified. Other portfolios that deviate from the total-market portfolio are never "more diversified" than the total-market portfolio. In other words, it is impossible for any other portfolio to have both a higher expected return and lower risk than the total-market portfolio."

Question for you, Trev H : Are you tilting to possibly take advantage of the "small value premium", or are you tilting because you see that TSM is mostly large cap and hence doesnt look diversified ? In other words, would you still tilt if past data had shown that small/value did not have any outperformance ?
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Post by Tonen »

bluejeansman, I was looking at Trev's post too
Trev H wrote:MrMatt...
It is also true that the Slice/Dice investor going as far as 50/50 Large Market / Small Value (since 1970 - rebalanced yearly) have had much better risk adjusted (Sharpe Ratio) returns, and lower Volatility - than the Lumper/TSM investor.

IMO - TSM is the most risky way to hold US Equities.

If you look at all of the 10 year rolling periods (since 1970 or 1929) Lumping everyhing into TSM = very risky.

LB/SV = much better bet even at 50/50 weightings.

It simply pays to diversify.

TSM is nothing but an illusion of diversification. You might as well hold nothing but US Large Market.

=====
I personally am about 50% tilted SV (using DFA Core funds) to load up on some risk, so I don't get too excited about TSM = the efficient frontier beyond the theory.

To some extent, I think Trevs approach confuses diversification with returns. A 50 % tilt to small value gives a higher expected return, and that was in fact what happened. I doubt the rebalancing helped. I think there is probably a trending rather than mean reverting return advantage for SV over LB, so I suspect buy and hold 50/50 LB/SV would have done better again (and with lower costs :) ).

On the other hand I dont have a good explanation for the improvement in volatility, so to that extent, Trev is right. Others in the thread have observed volatility is lower than it ought to be for SV. So, if you load up on SV, that risk measure will likely reduce, as Trev found. Maybe the anomoly is explicable by some cost of capital model. Might be a good question for Fama or French to chew over.
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Post by richard »

speedbump101 wrote:"A companies cost of capital is the investors expected return. Small value companies therefore have higher expected returns than large growth companies. Long-term increases in expected return can only be achieved by accepting greater small cap and / or value risk."
That cost of capital equals expected return must be true. It's essentially the same as saying store revenue equals customer spending at the store.
Small value companies therefore have higher expected returns than large growth companies
It is not at all clear that "therefore" is appropriate there. You have to assume that small value companies have higher cost of capital, which is not obvious.

Small value has returned more than large growth over many time periods. It could be a risk story, a behavioral story or just coincidence (aka luck). Whether SV will return more the LG in the future is anyone's guess.

Even if you believe it's a risk story, one of the problems with risk is that it may manifest, wiping out your increased returns or possibly your investment. Risk that doesn't include the possibility of bad outcomes is not risk.
bluejeansman
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Post by bluejeansman »

>>> You have to assume that small value companies have higher cost of capital, which is not obvious.

From the link referenced above : http://www.tma-invest.com/files/Asset_class_funds.pdf : I quote :
"because they are riskier, financially less healthy 'value' companies have higher costs of capital than financially healthy 'growth' companies. <u>When they borrow from a bank, value companies pay higher interest rates. Likewise when they issue stock, they receive lower prices</u>." Similarly if a small noname outfit approaches a bank, the bank would charge a higher rate of interest than if Microsoft approached the bank.

So I guess I understand the high "cost of capital" that small/value have.

But I totally fail to understand the statement : "cost of capital equals expected return". Could someone please explain this in layman terms ? Are we saying that if I and a group of "ninja" guys start a business venture, borrow from a bank at high rates of interest (high cost of capital), then you as an investor investing in us "ninja" guys automatically have a higher expected return ? I dont quite follow this.

It would be great if someone can comment on the other doubts I raised above :
(i) Large caps are the ones that typically generate income, i.e dividends. Many large caps generate increasing dividends as well, which when reinvested, should lead to high returns. Yet the results show small caps (which pay zero dividends) outperforming large.
(ii) the arbitrage issue.

Cheers.
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Post by grok87 »

richard wrote:
speedbump101 wrote:"A companies cost of capital is the investors expected return. Small value companies therefore have higher expected returns than large growth companies. Long-term increases in expected return can only be achieved by accepting greater small cap and / or value risk."
That cost of capital equals expected return must be true. It's essentially the same as saying store revenue equals customer spending at the store.
Small value companies therefore have higher expected returns than large growth companies
It is not at all clear that "therefore" is appropriate there. You have to assume that small value companies have higher cost of capital, which is not obvious.

Small value has returned more than large growth over many time periods. It could be a risk story, a behavioral story or just coincidence (aka luck). Whether SV will return more the LG in the future is anyone's guess.

Even if you believe it's a risk story, one of the problems with risk is that it may manifest, wiping out your increased returns or possibly your investment. Risk that doesn't include the possibility of bad outcomes is not risk.
Well one way to hedge this is to put all of the bond part of your portfolio in treasuries. If the risk of small cap value shows up, say in a bad recession/depression, then hopefully treasuries will do well. In other words the combination of small cap value stocks and treasuries may be superior to the standard "Total Stock Market Index/Bond Market Index" combination.
cheers,
RIP Mr. Bogle.
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Post by grok87 »

bluejeansman wrote: (i) Large caps are the ones that typically generate income, i.e dividends. Many large caps generate increasing dividends as well, which when reinvested, should lead to high returns. Yet the results show small caps (which pay zero dividends) outperforming large.
It's not clear that dividend paying stocks outperform. Mogliani/Miller's dividend irrelevance theorem states that paying dividends should be irrelevant from a total return perspective. Behavioralists think that investors who rely on dividend paying stocks to "ration" their withdrawals ("spend the dividend but don't touch capital") may bid dividend paying stocks and thus lower returns might be expected.
cheers,
RIP Mr. Bogle.
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Post by bluejeansman »

>> It's not clear that dividend paying stocks outperform. Mogliani/Miller's dividend irrelevance theorem ...

Vow ! I would have never guessed there is a theorem for this. interesting. Thanks.

However I have my doubts about these idealized mathematical models and reality. The models assume that everyone is cool, calculating, rational which is not necessarily true.

By the way, the Motley Fool UK runs a "High Yield portfolio" which I believe has been beating the FTSE AllShare since inception. Neil Woodford's Invesco Perpetual managed mutual fund is also based to a great extent on dividend investing and has beaten the market consistently.

In essence you have used an arbitrage argument. Those who rely on income yielding stocks may bid up the stock. But we could use this argument for just about anything, right ? For instance, because everyone knows about small/value outperformance, everyone will get on the bandwagon, bidding up the stocks. Consequently no future outperformance. Everyone knows about low cost index funds, so everyone is going to pile on, bidding up the entire stock market, thereby reducing returns.

Also, what about the point that 90%+ of stock market returns come from dividends reinvested ?

I find this whole subject : finance / portfolio theory interesting and worrying / frustrating at the same time. Nobody can say what is true, we cannot rely on past data, So how is an investor supposed to assimilate all this information and decide on their personal portfolio and more importantly, stick to it no matter what new evidence emerges ?
grok87
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Post by grok87 »

bluejeansman wrote:>> It's not clear that dividend paying stocks outperform. Mogliani/Miller's dividend irrelevance theorem ...

Vow ! I would have never guessed there is a theorem for this. interesting. Thanks.

However I have my doubts about these idealized mathematical models and reality. The models assume that everyone is cool, calculating, rational which is not necessarily true.

By the way, the Motley Fool UK runs a "High Yield portfolio" which I believe has been beating the FTSE AllShare since inception. Neil Woodford's Invesco Perpetual managed mutual fund is also based to a great extent on dividend investing and has beaten the market consistently.

In essence you have used an arbitrage argument. Those who rely on income yielding stocks may bid up the stock. But we could use this argument for just about anything, right ? For instance, because everyone knows about small/value outperformance, everyone will get on the bandwagon, bidding up the stocks. Consequently no future outperformance. Everyone knows about low cost index funds, so everyone is going to pile on, bidding up the entire stock market, thereby reducing returns.

Also, what about the point that 90%+ of stock market returns come from dividends reinvested ?

I find this whole subject : finance / portfolio theory interesting and worrying / frustrating at the same time. Nobody can say what is true, we cannot rely on past data, So how is an investor supposed to assimilate all this information and decide on their personal portfolio and more importantly, stick to it no matter what new evidence emerges ?
I think you are right to be skeptical of idealized mathematical models. But I think the behavioral arguments cut both ways (i.e. can argue for dividend stocks outperforming or underperforming). Here's Moglidiani Miller
http://en.wikipedia.org/wiki/Modigliani-Miller_theorem
Fama and French did the research that found small cap and value stocks outperforming. I don't think they found a strong link between dividends and outperformance.
cheers,
RIP Mr. Bogle.
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Post by Tonen »

bluejeansman wrote: I find this whole subject : finance / portfolio theory interesting and worrying / frustrating at the same time. Nobody can say what is true, we cannot rely on past data, So how is an investor supposed to assimilate all this information and decide on their personal portfolio and more importantly, stick to it no matter what new evidence emerges ?
That puts you ahead of those who think they do :)
Accepting we dont know means less likely to fiddle with things later on. I/N investing with in a vague context of total markets isn't a bad way to go.

1. Bond exposure for age (for me that'll be age -20 bonds, max 50%)
2. Bonds coupon vs inflation (50/50 there's the 1/N thing). All domestic - hedging = tax (see 5)
3. Adjust equities for domestic vs international (for me, 50/50- the 1/N thing again)
4. Add a couple of distinct asset classes somewhere between a 1/N basis and Total world markets (thats 10% EM, 20% REIT, 70% developed for me - nice round numbers with some semblence to (not necessarily listed) world markets)
5. Control and optimise costs, including tax.

Given there is no great science involved in steps 1-4, its pretty hard to be impressed with anything much, and little temptation to fiddle. Issues related to 5 though can impress me greatly and may lead to modifications if the numbers stack up.
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Post by bluejeansman »

Thanks grok/Tonen.

Tonen : didnt understand the acronyms.
1 : "Age - 20 bonds" : didnt get that
2 : Whats the "1/N thing" ?

Here is an interesting response from a Fool UK poster who does not agree with small/value premium.
http://boards.fool.co.uk/Message.asp?mi ... sort=whole

I wonder if it is a grographical thing, where the small/value premium has been observed only in U.S. Is that possible ?! Or, perhaps it is still relatively new (Fama/French : mid 90s).

I dont know why, but out here in U.K, "income investing", i.e dividend investing seems to be quite popular. Even Vanguard U.K has come out with "U.K Equity income index" as one of the fund offerings. But nobody (except DFA UK) has offered small/value tracker funds/ETFs.
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Post by kenner »

It's early, so thinking out loud. Seems to me that total, overall cost of capital should be a better measure of the market's perception of SV risk than would be a focus on dividends only. After all, a company's real cost of capital must take into account the total capital structure of a company (public debt, private debt, equity, hybrid, etc.). Moreover, some companies reduce their cost of capital by paying dividends; some optimize their capital structure (lower their cost of capital) by retaining earnings.

The market will not provide capital to a company unless the market's demand for a suitable expected return is satisfied. This does not necessarily mean that the expectation of return will be met in every case. That is part of the risk. It also explains why, over the long run, cost of capital equals expected return.

Nevertheless, an investor can construct a solid investment portfolio without doing a Ph.D. analysis of these factors.

Jason Zweig is one of America's premier financial minds (you could look it up). He has access to all the research and analysis discussed here. An investor following his simple example (in the manner recommended by Warren Buffet, John Bogle and other investment luminaries) would be well served over the long term. Jason states:

“I think the TSM vs. Slice-and-Dice “debate” generates much more heat than light. Slice-and-dice has obvious efficiencies for those who want to manage their accounts actively for tax reasons. But I don’t believe the investment advantage is very great, for several reasons.

First, the long-term historical outperformance of small caps is overstated (perhaps even illusory) because transaction costs are rarely included in the reported returns. The “value premium” is robust and there are psychological reasons to expect it to persist, but it is not huge, nor is it constant. Making big tilts toward these factors does not hold a lot of appeal for me.

Second, if you do not believe you can pick which particular stocks or managers will outperform the market, why would you think you can pick which market will outperform? If the whole cannot be greater than the sum of the parts, by what logic should we conclude that the sum of the parts should be greater than the whole? If you slice TSM into its constituent pieces and then put them back together with different weights, why should the weights you have chosen individually be superior to the weights that 100 million investors have already chosen collectively?

Third, if slice-and-dice makes sense for US stocks, why doesn’t it make equal sense for international stocks? Emerging markets? International bonds? Taxable bonds? Tax-free bonds? REITS? Finally, what’s the magic in the number four? Why not slice into nine (as Morningstar does), or 12 or 16 (as some institutional investment consultants do)? In short, once you start, where do you stop?

In a taxable account, I can see a marginal advantage for slice-and-dice for those who have the time or a good advisor willing to put in the work. And it does have the important advantage of making indexing seem a little less boring, for those who want investing to be interesting. (Benjamin Graham would have said: “It gives the investor something to do.”) I don’t think slice-and-dice is foolish or necessarily wrong. But I’m dubious that it’s always worth the effort, especially for what Graham called “defensive investors,” or people who want to put minimal effort into money management.

I have worked diligently to strip my holdings down to what I can honestly call a “permanent autopilot portfolio.” I quite literally do nothing except dollar-cost-average monthly and add extra cash whenever I have the cash to add (another couple times a month, typically). I rebalance annually, but only in my 401(k) accounts. I do nothing else. (I do evaluate whether I need to add asset classes from time to time, and occasionally do so, as with TIPS in my IRA.) As someone who thinks about and writes about investing every minute of the day, the last thing I want to do in my spare time is think about my own accounts – let alone shuffle them around.

My style is probably too hands-off for many people, but it works for me.”
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Post by richard »

bluejeansman wrote:>>> You have to assume that small value companies have higher cost of capital, which is not obvious.

From the link referenced above : http://www.tma-invest.com/files/Asset_class_funds.pdf : I quote :
"because they are riskier, financially less healthy 'value' companies have higher costs of capital than financially healthy 'growth' companies. <u>When they borrow from a bank, value companies pay higher interest rates. Likewise when they issue stock, they receive lower prices</u>." Similarly if a small noname outfit approaches a bank, the bank would charge a higher rate of interest than if Microsoft approached the bank.
They entire question is whether small value companies are riskier. SV is defined based on the ratio of book value to market price, which does not necessarily correlate to riskiness. Studies of the interest rates charged these companies are not consistent. If borrowing costs were the key, why not chose based on borrowing costs?
bluejeansman wrote:But I totally fail to understand the statement : "cost of capital equals expected return". Could someone please explain this in layman terms ?
Cost of capital is what the company must pay to attract capital. Expected return is what the providers of capital are charging for that capital.

As in any purchase, what the seller charges equals what the buyer pays. In this case, we don't know what will happen, so we don't know what the actual payments will be, we only know what is expected to happen.
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Post by Rodc »

Another interesting paper:

http://icf.som.yale.edu/pdf/badbeta.pdf

And another look at tilting and risk (at least a look at risk that showed up):

http://www.bogleheads.org/forum/viewtopic.php?t=11877
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.
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Post by George-J »

ObliviousInvestor wrote:...(And perhaps I'm strange, but I find it fascinating to note that in the case of value stocks, "risk" is not necessarily equated to volatility, like it so often is.)
Perhaps risk in this case "comes from the nature of being in certain kinds of businesses"

Warren Buffet was asked this question at a recent Berkshire annual meeting in Omaha.
Here is the question and answer exchange:
Question: What are your thoughts on tracking volatility in an attempt to measure risk?

Buffett: "Volatility does not measure risk. Beta, which is a measure of volatility,
is nice and mathematical, and wrong. Past volatility does not measure the risk of
investing now. Risk comes from the nature of being in certain kinds of
businesses and from not knowing what you're doing."
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Post by Tonen »

bluejeansman wrote:Thanks grok/Tonen.

Tonen : didnt understand the acronyms.
1 : "Age - 20 bonds" : didnt get that
2 : Whats the "1/N thing" ?
eg Age 48 = 28 % bonds/ 72% equities - thats high for many, but suits my particular circumstances. I plan to max out at 50% bonds, mainly as I think I will be leaving an inheritance, otherwise I wouldn't cap it.

1/N means when you know you really don't have much of a clue, just divide 1 by number of whatever you are thinking about. Has a pretty long history - a proverb from a couple thousand years ago was "Let every man divide his money into three parts, and invest a third in land, a third in business, and a third let him keep by him in reserve".
I/N is also called naive diversification, and has some more recent support eg http://rfs.oxfordjournals.org/cgi/conte ... act/hhm075 "We evaluate the out-of-sample performance of the sample-based mean-variance model, and its extensions designed to reduce estimation error, relative to the naive 1/N portfolio. Of the 14 models we evaluate across seven empirical datasets, none is consistently better than the 1/N rule in terms of Sharpe ratio, certainty-equivalent return, or turnover, which indicates that, out of sample, the gain from optimal diversification is more than offset by estimation error."

Bonds - coupon vs inflation? Whats best? Dunno. just split the difference (1/2).
Equities - dunno either. Broadly, there is developed, emerging, REIT. But 1/3 each is way, way off market weight ie equal developed / emerging/ REIT just seems weird. Equities 4 domestic, 3 developed, 2 REIT (overweight recognizing lots and lots of real estate investment isn't listed), 1 EM seems no stupider than any other ratio, and the triangular numbers appeal.
Is the small value premium real? Maybe worth a shot, but dunno. Worth a 50/50 split then - large blend/ SV.

The advantage of this approach is it inoculates you from making allocations on some clever method subject to big estimation errors, that risks being modified by some invariably costly to implement (apparently) cleverer method later on. Vaguely market weights, with a nod to various obvious issues (eg you probably need at least half your equities where you plan to live out your days, maybe a small value tilt, etc) and all the noise from the investing universe becomes a yawn, apart from costs. 1/N also tends to minimise decisional regret - there seems to be a bright side whatever happens.
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Post by bluejeansman »

Tonen,

Brilliant. Thanks for the explanation. I suppose it makes sense to spread things around a bit and hedge your bets.
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Post by Rodc »

bluejeansman wrote:Tonen,

Brilliant. Thanks for the explanation. I suppose it makes sense to spread things around a bit and hedge your bets.
This is similar to the advice given by Merriman: http://www.fundadvice.com/articles/buy- ... ategy.html

I don't use this myself, but I like the idea that it gets one out of the game of trying to figure out what exact percentage of this and that to hold. Many people, IMHO, spend way more thought and worry on this since we will never know going forward what is going to be best.

1/n does not work so well when applied to a 401K where for example there are 10 large cap growth funds, one small cap, two international and one bond fund...
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.
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Re: Why does small cap value outpreform?

Post by Chas »

kenner wrote:
From the noted financial writer and Boglehead friend, Dr. Bill Bernstein:

... This point cannot be made forcefully enough or often enough: high previous returns usually presage low future returns, and low past returns usually mean high future returns.
Ahh, another RTM and P/E10 believer.
Chas | | The course of true love never did run smooth. Shakespeare
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Re: Why does small cap value outpreform?

Post by Tonen »

Chas wrote:
kenner wrote:
From the noted financial writer and Boglehead friend, Dr. Bill Bernstein:

... This point cannot be made forcefully enough or often enough: high previous returns usually presage low future returns, and low past returns usually mean high future returns.
Ahh, another RTM and P/E10 believer.
Really? You missed out the next sentence of that Bernstein quote.
"The rub here is that buying when prices are low is always a very scary proposition. The low prices that produce high future returns are not possible without catastrophe and risk."

"Catastrophe and risk" does not equate "it'll all be better in the morning, just be brave, it'll all work out because you are tougher and smarter than the scaredy-cats". Catastrophe = out the back door is not impossible. Previous leading markets have suffered catastrophe, eg Russia, Argentina, Egypt. They are now classified as "Emerging" or "Frontier".

Markets going to ground also go through a time of PE 10, a time of PE 5 and at worst maybe PE 1/0. (Now that's cheap! If only my Excel spread sheet would still work?). Of course, if a century or two later it's "obvious" to some observers why some failed and the survivors survived, then none of this will cause concern while they analyse the tea leaves of the success stories. Who cares about the losers?
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Post by bluejeansman »

Rodc >> This is similar to the advice given by Merriman: http://www.fundadvice.com/arti....ategy.html

Yes, I have seen that. Before visiting Bogleheads, I used to think that was the ultimate portfolio. But many seemingly knowledgeable people have opined here that you dont need that level of complexity.

we have debated this to death and I am no wiser. Even 50/50 TSM/SV portfolio doesnt sound "spreading your bets evenly" - It is heavily tilted to small/value. SV is only currently 3% of TSM. Small is only 10% of TSM.

Maybe considering TSM as core and sprinkling whatever amount of SV you are "comfortable" with, maybe an option. But to be honest, I dont know what "comfortable" means. Perhaps it is about how much you are willing to gamble that SV will outperform total market.

But also, by definition, market cap weighted TSM favours largest companies. As someone else pointed out, even the small caps in TSM are the largest small-caps. That again makes me question how diversified a portfolio is that has an inherent bias towards large.

Also, outside US, it appears difficult to get index funds for small, value, small-value etc. So we are pretty much restricted to TSM. Is it worth paying 1.5% expenses for a managed small-cap fund ? I dont know.

regarding portfolio theory, if it is a science, we must be able to say something reasonably conclusive : For instance, dividend investing (which pretty much means large caps) as opposed to small-caps. Depending on whom you read, each one sounds very convincing. But they are opposite. I wonder what kind of academic discipline this is. Looks like I can prove just about anything using data-mining.

This is worse than quantum mechanics. Quantum mechanics may be wierd and completely non-understandable, but at least the predictions are sound and accurate. But in finance, we cant explain, we cant predict, and if you find something and publish it, it will be arbitraged away. whats the point ?
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Post by richard »

Tonen wrote:1/N means when you know you really don't have much of a clue, just divide 1 by number of whatever you are thinking about.
Behavioral studies have shown that many people use this approach in their 401(k)s when they are given a bunch of investment choices.

For example, if there are 8 large cap stock fund and 2 bond fund, they'd invest 10% in each. Alas, this can result in very bad choices. 80% equities can be a terrible choice for someone about to retire. I'll leave it to you to construct other examples in which 1/N fails badly.

As bluejeansman notes, small value makes up less than 5% of the market. To say that you're undecided between total market and small value and therefore you'll invest 50% in each is a similarly bad choice, IMO. Fama's standard advice is better for this type of decision: start with TSM, tilt to SV to the extent you want to take on more risk in the hope of a higher return.
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Post by richard »

bluejeansman wrote:This is worse than quantum mechanics. Quantum mechanics may be wierd and completely non-understandable, but at least the predictions are sound and accurate. But in finance, we cant explain, we cant predict, and if you find something and publish it, it will be arbitraged away. whats the point ?
Very well said.

Engineers, physicists and others who are good at statistics often make terrible investors, because they expect the market to be predictable or at least analyzable. It isn't, because we don't have enough reliable data and, perhaps more important, because investors change their behavior in reaction to information, arbitraging away anything that has worked to beat the market on a risk-adjusted basis.

That's why many of us end up with passive portfolios in generally market proportions, adjusted for individual circumstances (e.g., older, higher net worth people having less in equities).
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Post by bluejeansman »

> Engineers, physicists and others who are good at statistics often make terrible investors

Sorry to digress completely away from the topic, but among the professional community, that may not be entirely accurate. Almost all of the "quants" on Wall Street are Math/Physics PhDs. The most successful hedge fund is Renaissance Technologies, started by a mathematician. They hire a lot of scientist types. 30%+ returns since 1989. I wouldnt mind those returns.

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

I wonder what it is they do. Perhaps leverage amplifies their profits, but it cant be that alone.
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Re: Why does small cap value outpreform?

Post by mclovin »

kenner wrote:
Vanguard stock index funds, average annual return, last ten years (as of 8/31/09):

Small-Cap Index 5.06%
Small-Cap Growth 5.89%
Small-Cap Value 6.81%

Past returns have no bearing on future returns, especially over short investment time horizons.
I am confused. How could both the Small-Cap growth and the Small-Cap value beat the overall Small-Cap index?
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Re: Why does small cap value outpreform?

Post by madsinger »

bstgeorge wrote:I am confused. How could both the Small-Cap growth and the Small-Cap value beat the overall Small-Cap index?
Up until 2003 (I think, maybe 2004), the Small Cap Index fund tracked the Russell 2000 index, while the Small Cap Growth and Small Cap Value indexes tracked something else.

Looking at the past five years of returns (when these three funds tracked the same pool):

Code: Select all

                    YTD   1-year  5-year
Small Cap Value:  25.58%  -6.53%  2.54%
Small Cap:        30.79%  -4.08%  3.65%
Small Cap Growth: 35.91%  -2.08%  4.54%
things have become a little more what you'd expect.

-Brad.
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Post by richard »

bluejeansman wrote:> Engineers, physicists and others who are good at statistics often make terrible investors

Sorry to digress completely away from the topic, but among the professional community, that may not be entirely accurate. Almost all of the "quants" on Wall Street are Math/Physics PhDs. The most successful hedge fund is Renaissance Technologies, started by a mathematician. They hire a lot of scientist types. 30%+ returns since 1989. I wouldnt mind those returns.

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

I wonder what it is they do. Perhaps leverage amplifies their profits, but it cant be that alone.
Often does not mean always :D

There are lots of quants who make a lot of money. There are lots who don't. Pointing to a single very successful hedge fund does not say any more about the general success of quants than pointing to a mutual fund that has beat the market for a significant period and saying active management works or saying that its strategy (they all have some strategy) is a good idea.

Way off topic, but there was an article last year about someone who came up with formulas for reproducing the results of a very large number of hedge funds.

If you haven't read it, check out Andrew Lo's paper on Capital Decimation Partners. http://gloriamundi.org/picsresources/loa2.pdf
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Post by kenner »

Not sure why any investor would focus so much on dividends, especially when their perception is based on erroneous assumptions.

Bluejeansman wrote:

"It would be great if someone can comment on the other doubts I raised above :
(i) Large caps are the ones that typically generate income, i.e dividends. Many large caps generate increasing dividends as well, which when reinvested, should lead to high returns. Yet the results show small caps (which pay zero dividends) outperforming large."

Dividend yield as of 09/30/2009:

Large Cap Stocks (VFINX) 2.03%

Small Value Stocks (VISVX) 2.24%

Who says Small Caps pay "zero dividends"?
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