One View on Small Cap and Value Investing

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Rick Ferri
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One View on Small Cap and Value Investing

Post by Rick Ferri » Mon Jun 20, 2011 9:36 am

Here is a short and sweet explanation from the Oblivious Investor about why he doesn't overweight value stocks or small cap stocks.

By definition, a small-cap/value-tilted portfolio will have some periods in which it underperforms a “total market” portfolio and some periods in which it outperforms...If you’re somebody who would start to doubt your choice–and potentially back out on it at the worst time–during a period of relative underperformance, you should think twice about implementing a tilted portfolio.

I couldn't agree more. An investor shouldn't have value and small cap tilts if they're not going to be diciplined about maintaining those allocations during times of underperformance. I recall talking with a small cap value manager in 1999. His fund was hemorrhaging money as it was sucked into large cap growth funds. It didn't matter how compelling the valuations for small cap value stocks were at the time, investors couldn't stand to have an equity fund in their portfolio that wasn't keeping up with "the market".

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Re: One View on Small Cap and Value Investing

Post by Roy » Mon Jun 20, 2011 10:25 am

Rick Ferri wrote:Here is a short and sweet explanation from the Oblivious Investor about why he doesn't overweight value stocks or small cap stocks.

By definition, a small-cap/value-tilted portfolio will have some periods in which it underperforms a “total market” portfolio and some periods in which it outperforms...If you’re somebody who would start to doubt your choice–and potentially back out on it at the worst time–during a period of relative underperformance, you should think twice about implementing a tilted portfolio.

I couldn't agree more. An investor shouldn't have value and small cap tilts if they're not going to be diciplined about maintaining those allocations during times of underperformance. I recall talking with a small cap value manager in 1999. His fund was hemorrhaging money as it was sucked into large cap growth funds. It didn't matter how compelling the valuations for small cap value stocks were at the time, investors couldn't stand to have an equity fund in their portfolio that wasn't keeping up with "the market".

Rick Ferri


Yep. It's an old story but a good one. The problem is many DYI believe they can withstand the tracking error (various types) to a broad market that meaningful tilting must incur—ex ante. And I believe avoidance of potential regret may be the best reason to use Total Markets for equities. Not saying TSM is the better way, but I simply agree that emotions can be devastating and this should be respected—if possible before any painful illumination of the fact. It is also an area where a good advisor can offer navigational value should one choose to overweight anything.

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Post by grap0013 » Mon Jun 20, 2011 2:18 pm

Isn't tracking error everywhere? Look at my brother's big house. Look at my neighbor's hot wife. Everyone is buying gold. I would love to hear from some BGs who had a 50% or more SCV tilt and bailed on it at the wrong time (late 90s). I think this risk is overstated. I need some evidence, at least testimonial.
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Post by SVariance1 » Mon Jun 20, 2011 2:33 pm

IMO, the explicit quote is stating the obvious. Selling any investment at the wrong time is a bad idea. However, I think the implicit content here is that there is no merit in tilting towards small and value investing. I completely disagree.

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Post by RaleighStClaire » Mon Jun 20, 2011 2:46 pm

grap0013 wrote:Isn't tracking error everywhere? Look at my brother's big house. Everyone is buying gold. I would love to hear from some BGs who had a 50% or more SCV tilt and bailed on it at the wrong time (late 90s). I think this risk is overstated. I need some evidence, at least testimonial.


lol. never thought of tracking error and its relation to mismatch of hotness.
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Post by FireProof » Mon Jun 20, 2011 3:13 pm

That's part of why I don't tilt to value. I don't understand why value should perform better (all the risk stories seem weak to me) even though it has historically, so if it started to underperform, I would think that the market had just finally become efficient and doubt my choice. On the other hand, for tilting small, it's obvious why returns are better, due to greater risk. So no amount of underperformance fazes me at all (actually it just makes me more eager, because it seems more undervalued).

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Post by ObliviousInvestor » Mon Jun 20, 2011 3:35 pm

Thanks for sharing the article, Rick. :)

SVariance1 wrote:IMO, the explicit quote is stating the obvious.

Yes, very much so.

It's similar to how we might state the obvious when we say, "don't take on more volatility than you can handle." The real trick comes in knowing how much volatility is too much--and what allocation you should use to keep from having that much volatility.

In this case, the trick is to know whether or not tracking error (relative to the benchmark(s) of your choice) would bother you.

SVariance1 wrote:However, I think the implicit content here is that there is no merit in tilting towards small and value investing. I completely disagree.

Perhaps it came across that way, but if you read the first of the two articles, you'll see that that's not at all my position. My position is simply that small/value tiling is not right for me.
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Post by SVariance1 » Mon Jun 20, 2011 3:37 pm

Value and small should outperform over time and with the combination of the two, you get the most out performance. The data supports this. Value is theoretically riskier for obvious reasons and this should lead to out performance. That said, i prefer active managers for this exposure.

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Post by SVariance1 » Mon Jun 20, 2011 4:52 pm

ObliviousInvestor wrote:Thanks for sharing the article, Rick. :)

SVariance1 wrote:IMO, the explicit quote is stating the obvious.

Yes, very much so.

The real trick comes in knowing how much volatility is too much--and what allocation you should use to keep from having that much volatility.




I completely agree. Knowing your own risk tolerance can be challenging but you usually get a good sense of it during a severe downturn like we experienced during the credit crisis. Most investors are probably better off being more conservative than some questionnaire suggests.

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Post by yobria » Mon Jun 20, 2011 4:58 pm

SVariance1 wrote:Value and small should outperform over time and with the combination of the two, you get the most out performance. The data supports this. Value is theoretically riskier for obvious reasons and this should lead to out performance. That said, i prefer active managers for this exposure.


Unfortunately small growth, the sector that history says was supposed to underperform, has been the best performing bit of the market since such patterns became widely known.

A thing that everyone knows usually isn't worth knowing anymore, at least when it comes to investing.

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That's part of why I don't tilt to value.

Post by slowmoney » Mon Jun 20, 2011 5:02 pm

Fireproof wrote:

That's part of why I don't tilt to value…, I would think that the market had just finally become efficient.


IMO, actually NO the market is inefficient regarding value. In developing my IPS, I switched out of a value fund to a total stock market fund. Why? Several reasons:

1. The value premium story is, IMO, very over sold. Value investing is a relatively old, well known strategy. DFA, Buffet, value funds, etc. All kinds of people who think that they know more than other people have/are piling into value funds and this massive flow of liquidity has effectively squashed the value premium and maybe even guaranteed under performance. (speculation directing inefficiency in the market).

2. It is my understanding, that no one actually knows where this value premium comes from. There is NO fundamental reason for it. US Treasury bonds are FUNDAMENTALLY different than the US total stock market. They have decades and decades of history showing that they are not highly correlated and are fundamentally different.

3. There are so many other ways to tilt your portfolio that are based on fundamental differences or risk premiums. REITS are real estate. The stock company pays out near all the cash flows from the real estate. US real estate is fundamentally different from US Treasuries and the US stock market. International stocks are different than US stocks, not fundamentally different but different. Diversification is a free lunch. Why not have a good amount (50%) of your equity portfolio in international stocks for a free lunch? Really, you are going to make a huge bet on the continuing US stock market premium, how do you know that? For the record, I used to like chasing returns as well.


4. The Oblivious Investor wrote, “For whatever reason, I’ve come to have a strong suspicion of anything remotely clever when it comes to investing. Usually, when somebody promises higher expected returns without an increase in risk, they’re full of baloney.

Base your AA on fundamentals and not premiums that show up or don't. People who can self insure are always better off than people who buy insurance for a premium that they use or don't use or it doesn't cover enough anyway.
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Post by Optimistic » Mon Jun 20, 2011 5:12 pm

FireProof wrote:That's part of why I don't tilt to value. I don't understand why value should perform better (all the risk stories seem weak to me) even though it has historically, so if it started to underperform, I would think that the market had just finally become efficient and doubt my choice. On the other hand, for tilting small, it's obvious why returns are better, due to greater risk. So no amount of underperformance fazes me at all (actually it just makes me more eager, because it seems more undervalued).

Hi FireProof,
I used to feel the same way. It made since to me why small cap would have a higher expected return than large cap. But, I could not internalize why value should have a higher expected return than growth. Then, I read William Bernstein's The Four Pillars of Investing and it finally made since.

Bernstein describes growth stocks as "good companies" and value stocks as "bad companies". Something Bernstein says multiple times throughout the book is, "Good companies are generally bad stocks, and bad companies are generally good stocks." He compares Wal-Mart and Kmart (circa 2002). At the time, Wal-mart is a great company and Kmart has just filed Chapter 11. So, Wal-Mart is the epitome of Growth and Kmart the epitome of Value. Bernstein points out the following:
Since Kmart is a much riskier company than Wal-Mart, investors expect a higher return from Kmart than they do from Wal-Mart. Think about it. If Kmart had the same expected return as Wal-Mart, no one would buy it! So, its price must fall to the point where its expected return exceeds Wal-Mart's by a wide enough margin so that investors finally are induced to buy its shares. The key word here is expected, as opposed to guaranteed.

This simple explanation made the value risk premium "click" for me. That being said, if it doesn't ring true for you, don't tilt!

Respectfully,
Optimistic

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Post by SVariance1 » Mon Jun 20, 2011 5:24 pm

yobria wrote:
SVariance1 wrote:Value and small should outperform over time and with the combination of the two, you get the most out performance. The data supports this. Value is theoretically riskier for obvious reasons and this should lead to out performance. That said, i prefer active managers for this exposure.


Unfortunately small growth, the sector that history says was supposed to underperform, has been the best performing bit of the market since such patterns became widely known.



Nick


What time period are you are referencing? It might be true this year and perhaps over the past few years but I doubt that this would hold up under a long time period.

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Post by CABob » Mon Jun 20, 2011 5:32 pm

Rick, Mike, and others,
Do you feel the same way with other common "tilts" such as REIT and commodities?
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Post by GammaPoint » Mon Jun 20, 2011 5:32 pm

The phrase "the market is good enough for me" has always struck me as a bit odd. What market? It's not as if they really invest their money in the same weighting of all the investable assets out there. First they pick an arbitrary division between stocks and bonds (that has NOTHING to do with market weights), and then they often pick an arbitrary division between domestic and international. Investing in small cap and value stocks is not really that much different. But whatever floats your boat.

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Post by yobria » Mon Jun 20, 2011 5:42 pm

SVariance1 wrote:
yobria wrote:
SVariance1 wrote:Value and small should outperform over time and with the combination of the two, you get the most out performance. The data supports this. Value is theoretically riskier for obvious reasons and this should lead to out performance. That said, i prefer active managers for this exposure.


Unfortunately small growth, the sector that history says was supposed to underperform, has been the best performing bit of the market since such patterns became widely known.



Nick


What time period are you are referencing? It might be true this year and perhaps over the past few years but I doubt that this would hold up under a long time period.


It's certainly been the case over the last 10-15 years, since small growth and value funds became widely available.

The market just doesn't care about whatever historical patterns the world might have uncovered.

Nick

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Post by SVariance1 » Mon Jun 20, 2011 5:54 pm

yobria wrote:
SVariance1 wrote:
yobria wrote:
SVariance1 wrote:Value and small should outperform over time and with the combination of the two, you get the most out performance. The data supports this. Value is theoretically riskier for obvious reasons and this should lead to out performance. That said, i prefer active managers for this exposure.


Unfortunately small growth, the sector that history says was supposed to underperform, has been the best performing bit of the market since such patterns became widely known.



Nick


What time period are you are referencing? It might be true this year and perhaps over the past few years but I doubt that this would hold up under a long time period.


It's certainly been the case over the last 10-15 years, since small growth and value funds became widely available.

The market just doesn't care about whatever historical patterns the world might have uncovered.

Nick


Small Growth has not outperformed small value over the past 10 years. Not sure about 15

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Post by Blue » Mon Jun 20, 2011 5:56 pm

GammaPoint wrote:The phrase "the market is good enough for me" has always struck me as a bit odd. What market? It's not as if they really invest their money in the same weighting of all the investable assets out there. First they pick an arbitrary division between stocks and bonds (that has NOTHING to do with market weights), and then they often pick an arbitrary division between domestic and international. Investing in small cap and value stocks is not really that much different. But whatever floats your boat.


Agree. It's like the poster today bemoaning his underperformance relative to friend who went heavily into gold and contemplating the merits of being a boglehead.

Fear of tracking error is not the issue - the real issue at the end of the day having sufficient conviction in your allocation to stick with it when "tracking error" (I.e., underperformance) shows up.

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Re: One View on Small Cap and Value Investing

Post by jidina80 » Mon Jun 20, 2011 5:58 pm

Rick Ferri wrote: . . . An investor shouldn't have value and small cap tilts if they're not going to be diciplined about maintaining those allocations during times of underperformance.

Rick, I also couldn't agree more. About 10-12 years ago I eased REIT and Emerging Markets out of my portfolio for exactly the same reason. It really hurts to see a fund lag the total market year after year. Now I'm 'total markts' only - U.S. stock, international and bonds (except some TIPs). Less anxiety.

Just.

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Post by yobria » Mon Jun 20, 2011 6:02 pm

SVariance1 wrote:Small Growth has not outperformed small value over the past 10 years. Not sure about 15


10 year annualized total return through 6/17/2011:

Vanguard Small Growth Fund, VISGX: 8.42%
Vanguard Small Value Fund, VISVX: 7.18%

Source: Morningstar

Nick

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Post by SVariance1 » Mon Jun 20, 2011 6:09 pm

yobria wrote:
SVariance1 wrote:Small Growth has not outperformed small value over the past 10 years. Not sure about 15


10 year annualized total return through 6/17/2011:

Vanguard Small Growth Fund, VISGX: 8.42%
Vanguard Small Value Fund, VISVX: 7.18%

Source: Morningstar

Nick

Periods ending: June 20, 2011
Index name 10 Years


Small-cap indexes

Russell 2000® Growth Index 4.49
Russell 2000® Value Index 7.40

Didn't Vanguard change the target benchmarks a few years ago?

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Post by heyyou » Mon Jun 20, 2011 6:15 pm

A risk of owning Small and Value companies is the risk of those businesses failing. That risk and their pricing varies with economic conditions, but it does not ever fully go away. If Fama and French are refuted, that would be big news.

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Post by SVariance1 » Mon Jun 20, 2011 6:20 pm

heyyou wrote:A risk of owning Small and Value companies is the risk of those businesses failing. That risk and their pricing varies with economic conditions, but it does not ever fully go away. If Fama and French are refuted, that would be big news.


Yes of course but then the fun of figuring out which ones are unlikely to blow up begins :)

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Post by yobria » Mon Jun 20, 2011 6:33 pm

SVariance1 wrote:
yobria wrote:
SVariance1 wrote:Small Growth has not outperformed small value over the past 10 years. Not sure about 15


10 year annualized total return through 6/17/2011:

Vanguard Small Growth Fund, VISGX: 8.42%
Vanguard Small Value Fund, VISVX: 7.18%

Source: Morningstar

Nick

Periods ending: June 20, 2011
Index name 10 Years


Small-cap indexes

Russell 2000® Growth Index 4.49
Russell 2000® Value Index 7.40

Didn't Vanguard change the target benchmarks a few years ago?


Yes, they switched to the MSCI index, which supposedly is better constructed.

I guess what we can conclude from the numbers above is that either growth or value has outperformed, depending on the index used.

Going forward, I wouldn't place any big bets on one or the other.

Nick

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Post by SVariance1 » Mon Jun 20, 2011 6:52 pm

yobria wrote:
SVariance1 wrote:
yobria wrote:
SVariance1 wrote:Small Growth has not outperformed small value over the past 10 years. Not sure about 15


10 year annualized total return through 6/17/2011:

Vanguard Small Growth Fund, VISGX: 8.42%
Vanguard Small Value Fund, VISVX: 7.18%

Source: Morningstar

Nick

Periods ending: June 20, 2011
Index name 10 Years


Small-cap indexes

Russell 2000® Growth Index 4.49
Russell 2000® Value Index 7.40


Going forward, I wouldn't place any big bets on one or the other.

Nick


My bet will likely remain on Small Value, as has been the case for almost the past 20 years.

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Post by FireProof » Mon Jun 20, 2011 7:58 pm

Optimistic wrote:
FireProof wrote:That's part of why I don't tilt to value. I don't understand why value should perform better (all the risk stories seem weak to me) even though it has historically, so if it started to underperform, I would think that the market had just finally become efficient and doubt my choice. On the other hand, for tilting small, it's obvious why returns are better, due to greater risk. So no amount of underperformance fazes me at all (actually it just makes me more eager, because it seems more undervalued).

Hi FireProof,
I used to feel the same way. It made since to me why small cap would have a higher expected return than large cap. But, I could not internalize why value should have a higher expected return than growth. Then, I read William Bernstein's The Four Pillars of Investing and it finally made since.

Bernstein describes growth stocks as "good companies" and value stocks as "bad companies". Something Bernstein says multiple times throughout the book is, "Good companies are generally bad stocks, and bad companies are generally good stocks." He compares Wal-Mart and Kmart (circa 2002). At the time, Wal-mart is a great company and Kmart has just filed Chapter 11. So, Wal-Mart is the epitome of Growth and Kmart the epitome of Value. Bernstein points out the following:
Since Kmart is a much riskier company than Wal-Mart, investors expect a higher return from Kmart than they do from Wal-Mart. Think about it. If Kmart had the same expected return as Wal-Mart, no one would buy it! So, its price must fall to the point where its expected return exceeds Wal-Mart's by a wide enough margin so that investors finally are induced to buy its shares. The key word here is expected, as opposed to guaranteed.

This simple explanation made the value risk premium "click" for me. That being said, if it doesn't ring true for you, don't tilt!

Respectfully,
Optimistic

Then again, Bernstein also wrote this: http://www.efficientfrontier.com/ef/902/vgr.htm

"I submit, then, that although value and growth stocks have their own unique risks, those of growth stocks are more regular and pervasive. During a depression, growth companies may hold up better than value companies, though history has shown this to be an unreliable phenomenon. But when bubbles burst, you can take to the bank that growth will get whacked more than value. And, as long as there are human beings, there will be bubbles."

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Post by baw703916 » Mon Jun 20, 2011 8:15 pm

yobria wrote:
SVariance1 wrote:
yobria wrote:
SVariance1 wrote:Small Growth has not outperformed small value over the past 10 years. Not sure about 15


10 year annualized total return through 6/17/2011:

Vanguard Small Growth Fund, VISGX: 8.42%
Vanguard Small Value Fund, VISVX: 7.18%

Source: Morningstar

Nick

Periods ending: June 20, 2011
Index name 10 Years


Small-cap indexes

Russell 2000® Growth Index 4.49
Russell 2000® Value Index 7.40

Didn't Vanguard change the target benchmarks a few years ago?


Yes, they switched to the MSCI index, which supposedly is better constructed.

I guess what we can conclude from the numbers above is that either growth or value has outperformed, depending on the index used.

Going forward, I wouldn't place any big bets on one or the other.

Nick


Let me point out that 10 years ago, we were right at the thick of the dot.com bust. That's a pretty fortuitous starting point for good returns going forward.

Brad
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Post by ObliviousInvestor » Mon Jun 20, 2011 10:10 pm

CABob wrote:Rick, Mike, and others,
Do you feel the same way with other common "tilts" such as REIT and commodities?

Yes, I feel pretty much the same about other tilts.

That is, if 1) you believe that it improves your portfolio in some way, 2) you have a combination of sound historical evidence and sound common-sense explanation to back that up, and 3) you feel you can stick with it, then go for it.
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Post by tfb » Tue Jun 21, 2011 7:14 am

ObliviousInvestor wrote:In this case, the trick is to know whether or not tracking error (relative to the benchmark(s) of your choice) would bother you.

The argument has to go the other way as well.

"I don't invest in a total stock market fund because I'm afraid when I see small value perform better I might abandon the total stock market fund at the wrong time and chase performance in small value."

"I don't invest in bonds because I'm afraid when I see stocks doing much better than bonds I might sell bonds and buy stocks at the top."

"I don't invest in stocks because I'm afraid when I see stocks tanking I might sell stocks at the bottom."

If someone is going to abandon their plan at the wrong time, they will do it no matter what they invested in.
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Post by gkaplan » Tue Jun 21, 2011 7:37 am

I agree, which is why I don't have a problem with tracking error, as long as I acknowledge its possibility, in fact its inevitability.
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Post by Lbill » Tue Jun 21, 2011 7:39 am

Er, you also have to look at correlations. Adding SCV gives you a bit more diversification. You also have to consider the equity allocation percentage. Adding SCV means you can reduce the size of your equity allocation somewhat - see Larry Swedroe.
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Re: One View on Small Cap and Value Investing

Post by ddb » Tue Jun 21, 2011 8:03 am

Rick Ferri wrote:An investor shouldn't have value and small cap tilts if they're not going to be diciplined about maintaining those allocations during times of underperformance.


Yes, a re-worded version of "stay the course". Similarly, an investor shouldn't have equity exposure if they're not going to be disciplined about maintaining the equity allocation during times of underperformance.

Having said all that, I've never understood the aversion to potential tracking error against a broad-market index.

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Post by chaster86 » Tue Jun 21, 2011 8:06 am

Optimistic wrote:I used to feel the same way. It made since to me why small cap would have a higher expected return than large cap. But, I could not internalize why value should have a higher expected return than growth. Then, I read William Bernstein's The Four Pillars of Investing and it finally made since.

Bernstein describes growth stocks as "good companies" and value stocks as "bad companies". Something Bernstein says multiple times throughout the book is, "Good companies are generally bad stocks, and bad companies are generally good stocks." He compares Wal-Mart and Kmart (circa 2002). At the time, Wal-mart is a great company and Kmart has just filed Chapter 11. So, Wal-Mart is the epitome of Growth and Kmart the epitome of Value. Bernstein points out the following:
Since Kmart is a much riskier company than Wal-Mart, investors expect a higher return from Kmart than they do from Wal-Mart. Think about it. If Kmart had the same expected return as Wal-Mart, no one would buy it! So, its price must fall to the point where its expected return exceeds Wal-Mart's by a wide enough margin so that investors finally are induced to buy its shares. The key word here is expected, as opposed to guaranteed.

This simple explanation made the value risk premium "click" for me. That being said, if it doesn't ring true for you, don't tilt!


Yeah, but if investors are willing to buy it anyway just because it's a "value stock" then that risk goes away (offset by the increased probability of finding a greater sucker). Moreover, your logic is contrary to the entire purpose of valuation and investing in general, which is to identify stocks whose price must rise (not ones whose price must fall).

All you've done is find a way to rationalize performance chasing. IIt might very well "click" with you, but that doesn't mean it's true.

Passive investing only works when you hold the market because in that case there's no safe zone for anyone to attack your position. You cannot passively capture underpriced securities because they only remain underpriced so long as passive investors don't invest in them.

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Post by gkaplan » Tue Jun 21, 2011 8:08 am

Nor have I.
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Tracking Error Regret

Post by Random Walker » Tue Jun 21, 2011 8:21 am

People have been discussing tilting and not sticking with a plan do to tracking error regret. I'd like to point out that TE regret is a function of looking in the rearview mirror. When the price of an asset class declines, it's future expected return increases. Looking forward instead of backwards should help markedly prevent loss of discipline do to TE regret.
If one has a well thought out plan, he should enjoy the returns when his TE is positive, and look forward to increased future returns when the TE is negative.
Also, even if returns are no different than a total markets portfolio, the tilted portfolio should be more efficient than a whole markets portfolio because of the low correlations between small, value, and market. This should smoothe the ride over the long run.

Dave

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Re: Tracking Error Regret

Post by chaster86 » Tue Jun 21, 2011 1:01 pm

Random Walker wrote:Also, even if returns are no different than a total markets portfolio, the tilted portfolio should be more efficient than a whole markets portfolio because of the low correlations between small, value, and market. This should smoothe the ride over the long run.


That's crazy talk.

If small cap is uncorrelated with market then simple arithmetic will prove that it is even less correlated with large cap. So if combining uncorrelated assets is more efficient then the market combination of large and small is already the most efficient combination.

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Post by sperry8 » Tue Jun 21, 2011 3:09 pm

SVariance1 wrote:Value and small should outperform over time and with the combination of the two, you get the most out performance. The data supports this. Value is theoretically riskier for obvious reasons and this should lead to out performance. That said, i prefer active managers for this exposure.


I actually prefer the opposite for this exposure... index only for my value and small tilt. I use active for sectors (health care) and growth. For the reasons discussed in this thread - i dont want active managers selling at the wrong time.
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Post by SVariance1 » Tue Jun 21, 2011 5:44 pm

sperry8 wrote:
SVariance1 wrote:Value and small should outperform over time and with the combination of the two, you get the most out performance. The data supports this. Value is theoretically riskier for obvious reasons and this should lead to out performance. That said, i prefer active managers for this exposure.


I actually prefer the opposite for this exposure... index only for my value and small tilt. I use active for sectors (health care) and growth. For the reasons discussed in this thread - i dont want active managers selling at the wrong time.


That is a reasonable approach to value and small. I only own one sector - health and it is active. I don't own any growth funds or diversified index funds.

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Post by SVariance1 » Tue Jun 21, 2011 5:49 pm

SVariance1 wrote:
sperry8 wrote:
SVariance1 wrote:Value and small should outperform over time and with the combination of the two, you get the most out performance. The data supports this. Value is theoretically riskier for obvious reasons and this should lead to out performance. That said, i prefer active managers for this exposure.


I actually prefer the opposite for this exposure... index only for my value and small tilt. I use active for sectors (health care) and growth. For the reasons discussed in this thread - i dont want active managers selling at the wrong time.


That is a reasonable approach to value and small. I only own one sector - health and it is active. I don't own any growth funds or diversified index funds.

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Post by rustymutt » Tue Jun 21, 2011 5:55 pm

SVariance1 wrote:IMO, the explicit quote is stating the obvious. Selling any investment at the wrong time is a bad idea. However, I think the implicit content here is that there is no merit in tilting towards small and value investing. I completely disagree.


I have to agree. No investment plan can help a investor who doesn't stick with a plan. That doesn't mean the plan failed.
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Re: Tracking Error Regret

Post by baw703916 » Tue Jun 21, 2011 5:56 pm

chaster86 wrote: So if combining uncorrelated assets is more efficient then the market combination of large and small is already the most efficient combination.


I don't see how you can say that this is true.

Say you have Asset Class A and Asset Class B, which have some correlation less than 1. If each class individually has the same risk adjusted return, then the combination which gives the best overall risk-adjusted return should be a 50/50 combination (because that maximizes the effect of the less-than-perfect correlation between the two classes).

It could be the case that the optimal mix of A+B is 80%A/20%B--but that would imply that Class A has a better risk-adjusted return than B (taken individually).

How does the market weights of A and B enter into the calculation, unless it is implicitly contained in the risk-adjusted return?

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Post by SVariance1 » Tue Jun 21, 2011 8:16 pm

SVariance1 wrote:
SVariance1 wrote:
sperry8 wrote:
SVariance1 wrote:Value and small should outperform over time and with the combination of the two, you get the most out performance. The data supports this. Value is theoretically riskier for obvious reasons and this should lead to out performance. That said, i prefer active managers for this exposure.


I actually prefer the opposite for this exposure... index only for my value and small tilt. I use active for sectors (health care) and growth. For the reasons discussed in this thread - i dont want active managers selling at the wrong time.


That is a reasonable approach to value and small. I only own one sector - health and it is active. I don't own any growth funds or diversified equity funds.

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Re: Tracking Error Regret

Post by Roy » Wed Jun 22, 2011 7:03 am

Random Walker wrote:People have been discussing tilting and not sticking with a plan do to tracking error regret. I'd like to point out that TE regret is a function of looking in the rearview mirror. When the price of an asset class declines, it's future expected return increases. Looking forward instead of backwards should help markedly prevent loss of discipline do to TE regret.
If one has a well thought out plan, he should enjoy the returns when his TE is positive, and look forward to increased future returns when the TE is negative.
Also, even if returns are no different than a total markets portfolio, the tilted portfolio should be more efficient than a whole markets portfolio because of the low correlations between small, value, and market. This should smoothe the ride over the long run.
Dave


Dave,

I agree with you. I believe the argument applies also to other forms of overweighting or deviation that might cause significant portfolio variation from the broad market (e.g., a massive stake in REITS; Commodities; or on the portfolio level, implementing the Harry Browne Permanent Portfolio). But consistent adherence to disciplined logic is often challenging, as it is with other types of discipline in investing (tracking error being one)—a big one, in my view, among the DIY or among money managers.

On the tracking error issue, the weight of the media (not just the investing channels) reports on the general market (S&P 500). When markets are going good or bad, that generally refers to the fates of the S&P 500. Also, most 401ks and IRAs are still dominated by domestic Large Cap and the equity in those portfolios track closely to the S&P 500. That is an awful lot of manipulative (emotional) power residing in the broad market that does not apply co-equally to the Small Caps (and this can affect even pros, as Rick described, above). And even Larry Swedroe, who supports a significant exposure to Small Value for certain investors, has also written on the the topic of tracking error:

"The second consideration is a psychological one. It is risk called tracking error regret. For equities tracking error is the amount by which the performance of a portfolio varies from that of the total market, or other broad market benchmark such as the S&P 500 Index. By diversifying across risk factors you take on tracking error risk. While very few investors care when tracking error is positive (their portfolio beats the benchmark), it seems that most investors care when the tracking error is negative. To have a chance for positive tracking error, you must accept the almost certainty that negative tracking error will appear from time to time (or there would be no risk). And, unfortunately, the emotions that negative tracking error can lead to causes many investors to throw their well-thought-out plans into the trash heap. And losing discipline is a recipe for failure. Thus only those investors that are willing and able to accept tracking error risk should consider diversifying across the other risk factors."

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Post by Random Walker » Wed Jun 22, 2011 9:04 am

Roy,
You and I are on the same page. I think that essay of Larry's "Effective Diversification in a 3 Factor World" is 3 of the most valuable pages of investment reading found anywhere.
I agree with you on the importance of increasing portfolio efficiency by using substantial doses of non, weakly, or ideally negatively correlated asset classes. What amazes me is that several excellent books like Gibson's Asset Allocation make this point looking at multiple asset classes, but don't show the improved portfolio efficiency from big doses of small and value. They will talk about international, REITs, commodities, EM.

Chaster 86,
I think there is an error in your thinking. Total Markets index is way heavily loaded towards large growth. Correlation with large growth very high. So it may be diversified by number of stocks and number of asset classes. But it really does not provide significant exposure to diverse risk factors.
From what I remember the correlation coefficients are about as follows:
Market to value 0.14
Market to small 0.41
Small to value 0.14

Those numbers imply substantial positive effects on portfolio efficiency. And that's ignoring potential for increased returns. Smoother portfolio ride brings annualized return closer to average annual return.

Dave

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Post by Roy » Wed Jun 22, 2011 9:19 am

Random Walker wrote: You and I are on the same page. I think that essay of Larry's "Effective Diversification in a 3 Factor World" is 3 of the most valuable pages of investment reading found anywhere.


Yes. For its short length, it is a powerful piece that can affect implementation for those investors suitable to it but also for TSMers who choose to heed the caveats he mentions. The hallmark of a pro who thinks things through beyond his personal disposition on a topic.

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Post by Beagler » Wed Jun 22, 2011 12:07 pm

As the saying goes, if you can't stand the heat, get out of the kitchen.

And it's not just size- and value-tilted portfolios. Even investors drawn to this site were offered this advice to calm any market jitters viewtopic.php?t=26284

I'm not convinced of a generalized ability to stay the course even with a TSM-based portfolio.

Edit: typos corrected
Last edited by Beagler on Wed Jun 22, 2011 4:44 pm, edited 2 times in total.
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Post by RaleighStClaire » Wed Jun 22, 2011 12:11 pm

Do you really want to take the risk that history has been wrong? Small doesn't always beat large and value doesn't always been growth but as others have said, by investing in only TSM you are betting against value and small.

I'm sticking with small and value.

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Post by SVariance1 » Wed Jun 22, 2011 2:08 pm

Beagler wrote:As the saying goes, if you can't stand the heat, get outbox the kitchen.


I'm not convinced of a generalized ability to stay the course even with a TSM-based portfolio.


I think this depends on many factors such as experience, percentage of net worth at risk, etc.

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Post by SVariance1 » Wed Jun 22, 2011 2:16 pm

RaleighStClaire wrote:Do you really want to take the risk that history has been wrong? Small doesn't always beat large and value doesn't always been growth but as others have said, by investing in only TSM you are betting against value and small.

I'm sticking with small and value.



Well said. I would keep expectations in check, though. Valuations for small and value are not great.

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