Paul Merriman on small cap value tilt

[Nathan Drake]

I wish I had more time to peruse these forums.

Nispris nailed the OP question.

I too have left all tilting. Just much easier to 30/30/40 (or whatever AA) split the investable world and have done with it. Time is too precious to waste on chasing "extra" returns.

There's no time being wasted. You can invest in factors with a single fund if you so desire.

[rkhusky]

Overweighting SCV doesn't reduce risk, it compliments the profile of risk because it does not perform the same as the US TSM, while experiencing long term high returns. Both qualities are valuable and help optimize the portfolio.

The same is true for SCG, LCG, and LCV. In fact, holding TSM gives you four sectors that all perform a little bit differently - SCV, SCG, LCG and LCV.

[Jayy]

Overweighting SCV doesn't reduce risk, it compliments the profile of risk because it does not perform the same as the US TSM, while experiencing long term high returns. Both qualities are valuable and help optimize the portfolio.

The same is true for SCG, LCG, and LCV. In fact, holding TSM gives you four sectors that all perform a little bit differently - SCV, SCG, LCG and LCV.

Holding a subset of the group, e.g. only LCG if you expect SmB and HmL to both have negative premiums moving forward, allows for exposure to the additional factor risks in a portfolio. If you hold all of the subsets in TSM weights, SmB and HmL both zero out and you’re just capturing the market risk factor.

[rkhusky]

Overweighting SCV doesn't reduce risk, it compliments the profile of risk because it does not perform the same as the US TSM, while experiencing long term high returns. Both qualities are valuable and help optimize the portfolio.

The same is true for SCG, LCG, and LCV. In fact, holding TSM gives you four sectors that all perform a little bit differently - SCV, SCG, LCG and LCV.

Holding a subset of the group, e.g. only LCG if you expect SmB and HmL to both have negative premiums moving forward, allows for exposure to the additional factor risks in a portfolio. If you hold all of the subsets in TSM weights, SmB and HmL both zero out and you’re just capturing the market risk factor.

Right. So, you have to decide whether or not you want to take a gamble that one subset of the market will outperform the others.

[Taylor Larimore]

Bogleheads:

It is informative to learn how 8 professionally designed portfolios have performed during the past 10 years:

https://www.marketwatch.com/lazyportfolio%20

Note: Allan Roth's "Second Grader's Starter Portfolio" is "The Three-Fund Portfolio."

Best wishes.
Taylor

Jack Bogle's Words of Wisdom: "There may be better investment strategies than owning just three broad-based index funds but the number of strategies that are worse is infinite."

[garlandwhizzer]

I believe it is far more important for investing success to save some amount of your income regularly each month, invest that amount each month in a low cost widely diversified portfolio whether the market is up or down, and to stick with this discipline for decades. Much more important than whether you invest 100% in a market or a factor portfolio, the question we argue forever over on this Forum which really in the long run makes little differenc. It is safe to say that over multiple decades either investing approach will work effectively in terms of results. I personally am skeptical of academic factor research as to how totally unrealistic models translate into a short cut to investing success. I have plenty of good company in that opinion--Buffett and Bogle among them, both investing geniuses IMO. But in spite of that, I significantly overweight SCV relative to a market portfolio. Whether SCV will outperform going forward over the very long term especially in a risk adjusted manner I don't know up front. The SCV gravy train is certainly overdue but it could happen.

There are those of us who know we don't know how the market's future will unfold and others who don't know that they don't know it. All we have going forward is just a guess IMO. The good news is that both market and factor approaches have always led to success for those with sufficient patience while those without sufficient patience usually fail to do so.

I do have a firm belief that the market cycles through long decade plus periods when growth outperforms value and when large outperforms small. These periods alternate with long multi-year periods when value outperforms growth and small comes roaring back to outperform large. Hence the diversification appeal in holding holding both, a smoother ride on the roller coaster of the market volatility and paying little, if anything, for it in the long run. If you're in the retirement phase like me, needing to liquidate assets regularly to meet expenses, portfolio volatility poses a problem especially now when bonds, usually the safe port in the equity storm, remain in a deeper bear market than stocks. It's nice to have some asset that is not on sale at such a time. Cash/MMF has been that asset since inflation rose from the grave but I suspect its future will not be as bright as its past.

Garland Whizzer

[WhitePuma]

Bogleheads:

It is informative to learn how 8 professionally designed portfolios have performed during the past 10 years:

https://www.marketwatch.com/lazyportfolio%20

Note: Allan Roth's "Second Grader's Starter Portfolio" is "The Three-Fund Portfolio."

Best wishes.
Taylor

Jack Bogle's Words of Wisdom: "There may be better investment strategies than owning just three broad-based index funds but the number of strategies that are worse is infinite."

Taylor, I'd like to know what the fixed income (% of portfolio) and international stock allocations (% of equity) are for each of the indicated portfolios, including the Second Grader's Starter Portfolio. However, it doesn't show this on the site per your link, and when I clicked on a given portfolio, it requires a MarketWatch subscription. Do you know where I can learn what the actual allocations for each listed portfolio are?

[Bama12]

Does he or his company happen to sell these funds for a living?

No

[Nathan Drake]

Overweighting SCV doesn't reduce risk, it compliments the profile of risk because it does not perform the same as the US TSM, while experiencing long term high returns. Both qualities are valuable and help optimize the portfolio.

The same is true for SCG, LCG, and LCV. In fact, holding TSM gives you four sectors that all perform a little bit differently - SCV, SCG, LCG and LCV.

Holding a subset of the group, e.g. only LCG if you expect SmB and HmL to both have negative premiums moving forward, allows for exposure to the additional factor risks in a portfolio. If you hold all of the subsets in TSM weights, SmB and HmL both zero out and you’re just capturing the market risk factor.

Right. So, you have to decide whether or not you want to take a gamble that one subset of the market will outperform the others.

You're taking a "gamble" that Total market funds won't underperform bonds.

[Taylor Larimore]

Bogleheads:

It is informative to learn how 8 professionally designed portfolios have performed during the past 10 years:

https://www.marketwatch.com/lazyportfolio%20

Note: Allan Roth's "Second Grader's Starter Portfolio" is "The Three-Fund Portfolio."

Best wishes.
Taylor

Jack Bogle's Words of Wisdom: "There may be better investment strategies than owning just three broad-based index funds but the number of strategies that are worse is infinite."

Taylor, I'd like to know what the fixed income (% of portfolio) and international stock allocations (% of equity) are for each of the indicated portfolios, including the Second Grader's Starter Portfolio. However, it doesn't show this on the site per your link, and when I clicked on a given portfolio, it requires a MarketWatch subscription. Do you know where I can learn what the actual allocations for each listed portfolio are?

WhitePuma:

It used to be that I could click on each portfolio and see its composition. Today we can't do that. Maybe someone with a subscription will answer your question.

Best wishes
Taylor

Jack Bogle's Words of Wisdom: "There may be better investment strategies than owning just three broad-based index funds but the number of strategies that are worse is infinite."

[bluewalls]

I don’t know why people are so afraid of putting money in small cap value. I was convinced not by Paul Merriman, but by Ben Felix. My portfolio has been 50% AVUV, 40% AVDV, 10% DGS for a few years now. It’s very likely to outperform over the long term. If you can’t stomach putting your money in it and keeping it there without having doubts, then you shouldn’t do it. To me, it only makes sense. I am hoping Avantis comes out with an Emerging Markets Small Cap Value ETF. They just came out with Emerging Markets Small Cap.

[inittowinit]

I did SCV tilt for years.
Later discovered I didn't need it.
Not worth the hassle, so I simplified.
Less to worry about.

Ditto. Life’s much more straightforward sans tilt.

[rkhusky]

Overweighting SCV doesn't reduce risk, it compliments the profile of risk because it does not perform the same as the US TSM, while experiencing long term high returns. Both qualities are valuable and help optimize the portfolio.

The same is true for SCG, LCG, and LCV. In fact, holding TSM gives you four sectors that all perform a little bit differently - SCV, SCG, LCG and LCV.

Holding a subset of the group, e.g. only LCG if you expect SmB and HmL to both have negative premiums moving forward, allows for exposure to the additional factor risks in a portfolio. If you hold all of the subsets in TSM weights, SmB and HmL both zero out and you’re just capturing the market risk factor.

Right. So, you have to decide whether or not you want to take a gamble that one subset of the market will outperform the others.

You're taking a "gamble" that Total market funds won't underperform bonds.

It’s a vastly different situation. Bonds are fundamentally different from stocks. Total Bond has little correlation to Total Stock. The inherent differences mean that the riskier stocks are expected to outperform the more predictable bonds over most long stretches of time.

SCV, SCG, LCG, LCV are fundamentally the same and are well correlated to each other. Picking which one will outperform is difficult because there is no fundamental difference between them and the signal looks a lot like the noise.

[UpperNwGuy]

I don’t know why people are so afraid of putting money in small cap value.

I am not afraid. I just don't see the benefit.

[Nathan Drake]

The same is true for SCG, LCG, and LCV. In fact, holding TSM gives you four sectors that all perform a little bit differently - SCV, SCG, LCG and LCV.

Holding a subset of the group, e.g. only LCG if you expect SmB and HmL to both have negative premiums moving forward, allows for exposure to the additional factor risks in a portfolio. If you hold all of the subsets in TSM weights, SmB and HmL both zero out and you’re just capturing the market risk factor.

Right. So, you have to decide whether or not you want to take a gamble that one subset of the market will outperform the others.

You're taking a "gamble" that Total market funds won't underperform bonds.

It’s a vastly different situation. Bonds are fundamentally different from stocks. Total Bond has little correlation to Total Stock. The inherent differences mean that the riskier stocks are expected to outperform the more predictable bonds over most long stretches of time.

SCV, SCG, LCG, LCV are fundamentally the same and are well correlated to each other. Picking which one will outperform is difficult because there is no fundamental difference between them and the signal looks a lot like the noise.

It's not a vastly different situation. Correlations don't have anything to do with what we are discussing. We are talking about risk premiums. You are getting compensated EXTRA for Total Stock over Bonds precisely because they are riskier. The same is true for Value funds (not Growth which has not shown a risk premium). The fact that these funds tend to be long only means they will be correlated more, but that's not relevant to the discussion. They contain a loading on additional risk premiums and any overperformance or underperformance is on that basis.

[CyclingDuo]

Taylor, I'd like to know what the fixed income (% of portfolio) and international stock allocations (% of equity) are for each of the indicated portfolios, including the Second Grader's Starter Portfolio. However, it doesn't show this on the site per your link, and when I clicked on a given portfolio, it requires a MarketWatch subscription. Do you know where I can learn what the actual allocations for each listed portfolio are?

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CyclingDuo

[rkhusky]

It’s a vastly different situation. Bonds are fundamentally different from stocks. Total Bond has little correlation to Total Stock. The inherent differences mean that the riskier stocks are expected to outperform the more predictable bonds over most long stretches of time.

SCV, SCG, LCG, LCV are fundamentally the same and are well correlated to each other. Picking which one will outperform is difficult because there is no fundamental difference between them and the signal looks a lot like the noise.

It's not a vastly different situation. Correlations don't have anything to do with what we are discussing. We are talking about risk premiums. You are getting compensated EXTRA for Total Stock over Bonds precisely because they are riskier. The same is true for Value funds (not Growth which has not shown a risk premium). The fact that these funds tend to be long only means they will be correlated more, but that's not relevant to the discussion. They contain a loading on additional risk premiums and any overperformance or underperformance is on that basis.

Stocks are fundamentally different than bonds. Different flavors of stocks are not fundamentally different from each other. In fact, value stocks can turn into growth stocks and vice-versa. Large stocks can turn into small stocks and vice-versa.

Small growth has outperformed small value for the last 20 years. Large growth has outperformed large value for the last 20 years. Growth has a risk premium for the last 20 years.

[Call_Me_Op]

In this linked podcast: https://player.fm/series/sound-investin ... bogleheads , Merriman argues that a small value tilt is still worthwhile. Comments?

Makes no sense.

Small cap value universe is so small that if every one tilts then it will no longer be a tilt.

Sure there will - even though that will never happen. There is always a small-cap universe - the smallest X% in terms of market cap.

Which brings up a good point as to why the SCV premium could have (not necessarily has) gone away. If the great data scientists and super-computers of fintech all looking for an edge have identified the specific advantageous elements of the companies that were previously classified as SCV--the ones that actually drove the historical SCV outperformance--then those were now bid up to the point they are no longer SCV. But these categorical definitions are all relative. So now another set of companies, ones with a different profile, even if only slightly, are now all that's left of SCV, and those are the ones that we might not expect to see outperformance. Plausible, but is it reality? Let's check back in...oh, 40 years.

or perhaps the stocks the you say might not be expected to see out-performance will in fact be the set that outperforms - simply because they are now the stocks that are out of favor.

[Nowizard]

It fits for some, not for others in the back and forth between following experts views and the fact that they are no more accurate than reasonably well-versed amateurs. It has fit for us for many years.

Tim

[Nathan Drake]

It’s a vastly different situation. Bonds are fundamentally different from stocks. Total Bond has little correlation to Total Stock. The inherent differences mean that the riskier stocks are expected to outperform the more predictable bonds over most long stretches of time.

SCV, SCG, LCG, LCV are fundamentally the same and are well correlated to each other. Picking which one will outperform is difficult because there is no fundamental difference between them and the signal looks a lot like the noise.

It's not a vastly different situation. Correlations don't have anything to do with what we are discussing. We are talking about risk premiums. You are getting compensated EXTRA for Total Stock over Bonds precisely because they are riskier. The same is true for Value funds (not Growth which has not shown a risk premium). The fact that these funds tend to be long only means they will be correlated more, but that's not relevant to the discussion. They contain a loading on additional risk premiums and any overperformance or underperformance is on that basis.

Stocks are fundamentally different than bonds. Different flavors of stocks are not fundamentally different from each other. In fact, value stocks can turn into growth stocks and vice-versa. Large stocks can turn into small stocks and vice-versa.

Small growth has outperformed small value for the last 20 years. Large growth has outperformed large value for the last 20 years. Growth has a risk premium for the last 20 years.

You're discussing mechanics. I am discussing Premiums. If a Value stock turns into a Growth stock, then you capture the premium and sell the stock. The dynamics of how that plays out is part of the Factor selection process.

Growth has not outperformed value the last 20 years in all markets. Why are you only focusing on the US? Is that the entire universe of Growth vs Value stocks? Value has outperformed in Emerging and Developed markets. Further, one twenty year period doesn't discount the larger temporal trend of significant value outperformance overall. That's why there's a risk premium for Value and not Growth.

A period of time of underperformance is expected and part of the "risk" in "risk premium". Plenty of very long stretches where Stocks underperformed Bonds, just look at McQ's thread. We have multi-decade periods of this.

[rkhusky]

It’s a vastly different situation. Bonds are fundamentally different from stocks. Total Bond has little correlation to Total Stock. The inherent differences mean that the riskier stocks are expected to outperform the more predictable bonds over most long stretches of time.

SCV, SCG, LCG, LCV are fundamentally the same and are well correlated to each other. Picking which one will outperform is difficult because there is no fundamental difference between them and the signal looks a lot like the noise.

It's not a vastly different situation. Correlations don't have anything to do with what we are discussing. We are talking about risk premiums. You are getting compensated EXTRA for Total Stock over Bonds precisely because they are riskier. The same is true for Value funds (not Growth which has not shown a risk premium). The fact that these funds tend to be long only means they will be correlated more, but that's not relevant to the discussion. They contain a loading on additional risk premiums and any overperformance or underperformance is on that basis.

Stocks are fundamentally different than bonds. Different flavors of stocks are not fundamentally different from each other. In fact, value stocks can turn into growth stocks and vice-versa. Large stocks can turn into small stocks and vice-versa.

Small growth has outperformed small value for the last 20 years. Large growth has outperformed large value for the last 20 years. Growth has a risk premium for the last 20 years.

You're discussing mechanics. I am discussing Premiums. If a Value stock turns into a Growth stock, then you capture the premium and sell the stock. The dynamics of how that plays out is part of the Factor selection process.

Growth has not outperformed value the last 20 years in all markets. Why are you only focusing on the US? Is that the entire universe of Growth vs Value stocks? Value has outperformed in Emerging and Developed markets. Further, one twenty year period doesn't discount the larger temporal trend of significant value outperformance overall. That's why there's a risk premium for Value and not Growth.

A period of time of underperformance is expected and part of the "risk" in "risk premium". Plenty of very long stretches where Stocks underperformed Bonds, just look at McQ's thread. We have multi-decade periods of this.

The past is meaningless. The future is what counts. And the last 20 years is a better predictor of the future than what happened 50 years ago. There is nothing wrong with calculating the growth risk premium over the last 20 years. And I mainly invest in US stocks. Plus the initial FF papers used US stocks.

[Nathan Drake]

It’s a vastly different situation. Bonds are fundamentally different from stocks. Total Bond has little correlation to Total Stock. The inherent differences mean that the riskier stocks are expected to outperform the more predictable bonds over most long stretches of time.

SCV, SCG, LCG, LCV are fundamentally the same and are well correlated to each other. Picking which one will outperform is difficult because there is no fundamental difference between them and the signal looks a lot like the noise.

It's not a vastly different situation. Correlations don't have anything to do with what we are discussing. We are talking about risk premiums. You are getting compensated EXTRA for Total Stock over Bonds precisely because they are riskier. The same is true for Value funds (not Growth which has not shown a risk premium). The fact that these funds tend to be long only means they will be correlated more, but that's not relevant to the discussion. They contain a loading on additional risk premiums and any overperformance or underperformance is on that basis.

Stocks are fundamentally different than bonds. Different flavors of stocks are not fundamentally different from each other. In fact, value stocks can turn into growth stocks and vice-versa. Large stocks can turn into small stocks and vice-versa.

Small growth has outperformed small value for the last 20 years. Large growth has outperformed large value for the last 20 years. Growth has a risk premium for the last 20 years.

You're discussing mechanics. I am discussing Premiums. If a Value stock turns into a Growth stock, then you capture the premium and sell the stock. The dynamics of how that plays out is part of the Factor selection process.

Growth has not outperformed value the last 20 years in all markets. Why are you only focusing on the US? Is that the entire universe of Growth vs Value stocks? Value has outperformed in Emerging and Developed markets. Further, one twenty year period doesn't discount the larger temporal trend of significant value outperformance overall. That's why there's a risk premium for Value and not Growth.

A period of time of underperformance is expected and part of the "risk" in "risk premium". Plenty of very long stretches where Stocks underperformed Bonds, just look at McQ's thread. We have multi-decade periods of this.

The past is meaningless. The future is what counts. And the last 20 years is a better predictor of the future than what happened 50 years ago. There is nothing wrong with calculating the growth risk premium over the last 20 years. And I mainly invest in US stocks. Plus the initial FF papers used US stocks.

There's no use arguing. You will just hand waive larger data sets to fit your very narrowly defined narrative. There's a much larger investible universe than the one you ascribe to, with empirical backing that you can choose to ignore.

[nyejos11]

“And the last 20 years is a better predictor of the future than what happened 50 years ago. “

I would argue that absolutely nothing is a predictor of the future in any way. Just my 2cent

[drumboy256]

The problem with the absolute "pure" state of a 1,2,3, or even 4 portfolio is that it ends up being the scene out of the Princess Bride game of wits--- except, replace "Wine" with "Small Caps" and you get the point.

As others have said, "Value" by definition, means something to every investing house--- each investor, and to a market that tracks "value". What people like Paul get in spades, is the risk vector for investors based on their personal objectives. Just like anyone on this forum would tout "personal finance is in fact, personal..." so is risk based on portfolio allocation.

Such as, if we're to believe that the EMH (Efficient Market Hypothesis) is in fact the law of the land, then by that measure, beating the market based on portfolio of either 1,2,3, 4, or 5+ funds is irrelevant, at least in the conversation of "risk" since any portfolio by the definition of the term, is a risk that is not cash. Whether or not a person or persons need "small cap" or "value" stocks in their portfolio is based on their objectives and adherence to risk.

The antidote to "value" picking (imo) is to go with the Avantis All Equity Value ETF (AVGV) that does the mechanics of EMH or Anti-EMH for you. Does this take on or capture additional risk? No. In the truest form of Ben Felix saying "is it appropriate for someone to have value or small cap values as part of a portfolio? Probably...." Which to that point, diversification of said "risk" is what you bend the market's to your objectives for your own personal risk tolerance. It ain't rocket science, but boy howdy is it a tough nut to crack.

[Northern Flicker]

Investing in a single stock is purported to be higher risk than a broad based index fund. So, why isn’t the expected return of a single stock higher than the index fund?

The usual explanation is that the risk of single stocks is uncompensated risk. How do we know that the risk in a small value fund will be compensated risk?

Uncompensated risk is diversifiable risk. It is risk that is not compensated through additional expected return. Compensated risk is undiversifiable risk. It is compensated through additional expected return. The actual outcome is a different matter. We don't know if any equity investment will deliver its expected return until the outcome is known.

[BitTooAggressive]

Investing in a single stock is purported to be higher risk than a broad based index fund. So, why isn’t the expected return of a single stock higher than the index fund?

The usual explanation is that the risk of single stocks is uncompensated risk. How do we know that the risk in a small value fund will be compensated risk?

Uncompensated risk is diversifiable risk. It is risk that is not compensated through additional expected return. Compensated risk is undiversifiable risk. It is compensated through additional expected return. The actual outcome is a different matter. We don't know if any equity investment will deliver its expected return until the outcome is known.

Exactly correct as far as I know.

[rkhusky]

Investing in a single stock is purported to be higher risk than a broad based index fund. So, why isn’t the expected return of a single stock higher than the index fund?

The usual explanation is that the risk of single stocks is uncompensated risk. How do we know that the risk in a small value fund will be compensated risk?

Uncompensated risk is diversifiable risk. It is risk that is not compensated through additional expected return. Compensated risk is undiversifiable risk. It is compensated through additional expected return. The actual outcome is a different matter. We don't know if any equity investment will deliver its expected return until the outcome is known.

So, is SCV compensated risk?

[Northern Flicker]

Investing in a single stock is purported to be higher risk than a broad based index fund. So, why isn’t the expected return of a single stock higher than the index fund?

The usual explanation is that the risk of single stocks is uncompensated risk. How do we know that the risk in a small value fund will be compensated risk?

Uncompensated risk is diversifiable risk. It is risk that is not compensated through additional expected return. Compensated risk is undiversifiable risk. It is compensated through additional expected return. The actual outcome is a different matter. We don't know if any equity investment will deliver its expected return until the outcome is known.

So, is SCV compensated risk?

SCV is not an equity risk factor. Factor theory holds that the value factor and size factor are systematic risk factors that the market will compensate through additional expected return.

SCV stock, being exposed to both factors, is riskier than the market portfolio. Risk is a real thing. Higher risk usually means that the portfolio has a lower probability of achieving its expected return, or greater downside risk when it fails to deliver, or both. We sometimes see people writing that an investment is a high risk/high return investment. But risk is not a guarantor of return.

[rkhusky]

SCV is not an equity risk factor. Factor theory holds that the value factor and size factor are systematic risk factors that the market will compensate through additional expected return.

It’s more like the value and size factors have been compensated in the past. Not sure if there is any theory that says they will be compensated in the future.

[Nathan Drake]

SCV is not an equity risk factor. Factor theory holds that the value factor and size factor are systematic risk factors that the market will compensate through additional expected return.

It’s more like the value and size factors have been compensated in the past. Not sure if there is any theory that says they will be compensated in the future.

Can be re-worded as: The equity risk premium has been compensated in the past. Not sure if there is any theory that says they will be compensated for in the future.

[Northern Flicker]

SCV is not an equity risk factor. Factor theory holds that the value factor and size factor are systematic risk factors that the market will compensate through additional expected return.

It’s more like the value and size factors have been compensated in the past. Not sure if there is any theory that says they will be compensated in the future.

Past outperformance is still just an outcome. There is no way to know if that was due to a higher expected return or just a fortuitous outcome.

Investment theory posits that the market will compensate undiversifiable risk. The mechanism is by discounting future projected cash flows back to a present value using a steeper discount rate to reflect the greater uncertainty/risk that the future cash flows materialize. So you actually get the expected premium when you buy the asset at the discounted price. Whether or not the investment then delivers its expected return is a separate matter.

This is at the core of the definition of a value stock. It is a theory of investing, not a natural law, but if you do not accept it, you may want to divest from all stock. Investing in the market portfolio is already plenty risky, and the same mechanism forms the how and why equity risk is compensated with expected return.

Some points about equity factors:

1. You don't have to tilt. Investors can be successful with the market factor.

2. There are some questions about how to define some factors, or the best way to harvest them. You don't have to worry about that if you hold the market portfolio.

3. If you are willing to take more risk than the market portfolio to try to beat the market, factors provide a systematic framework for trying to do that, and can be implemented at low cost.

4. Some investors prefer to reduce their equity allocation some but tilt to equity factors to compensate for the change to have a portfolio they hope will offer better diversification.

5. Some investors use factors to design portfolios they hope will respond to inflation, disinflation, and deflation in a manner preferable to the market portfolio for their situation.

I would describe myself as a long time factor skeptic. I've never held more than a mild factor tilt, which I'm not convinced even matters all that much.

[BitTooAggressive]

SCV is not an equity risk factor. Factor theory holds that the value factor and size factor are systematic risk factors that the market will compensate through additional expected return.

It’s more like the value and size factors have been compensated in the past. Not sure if there is any theory that says they will be compensated in the future.

Can be re-worded as: The equity risk premium has been compensated in the past. Not sure if there is any theory that says they will be compensated for in the future.

Of course the theory says EXPECTED returns adding in small and value will be higher than the market alone in the future. The theory says nothing about actual returns as there is too much uncertainty in the world.

EXPECTED returns are very different than actual returns.

[rkhusky]

SCV is not an equity risk factor. Factor theory holds that the value factor and size factor are systematic risk factors that the market will compensate through additional expected return.

It’s more like the value and size factors have been compensated in the past. Not sure if there is any theory that says they will be compensated in the future.

Can be re-worded as: The equity risk premium has been compensated in the past. Not sure if there is any theory that says they will be compensated for in the future.

Stocks vs bonds is a strawman when comparing different shades of stocks.

[rkhusky]

SCV is not an equity risk factor. Factor theory holds that the value factor and size factor are systematic risk factors that the market will compensate through additional expected return.

It’s more like the value and size factors have been compensated in the past. Not sure if there is any theory that says they will be compensated in the future.

Can be re-worded as: The equity risk premium has been compensated in the past. Not sure if there is any theory that says they will be compensated for in the future.

Of course the theory says EXPECTED returns adding in small and value will be higher than the market alone in the future. The theory says nothing about actual returns as there is too much uncertainty in the world.

EXPECTED returns are very different than actual returns.

And what about small cap growth? From what people say, that is the riskiest sector, the black hole of investing. It should therefore have the highest expected return.

[Nathan Drake]

SCV is not an equity risk factor. Factor theory holds that the value factor and size factor are systematic risk factors that the market will compensate through additional expected return.

It’s more like the value and size factors have been compensated in the past. Not sure if there is any theory that says they will be compensated in the future.

Can be re-worded as: The equity risk premium has been compensated in the past. Not sure if there is any theory that says they will be compensated for in the future.

Stocks vs bonds is a strawman when comparing different shades of stocks.

Not at all

Stocks are priced with a higher expected value over risk free bonds, otherwise nobody would invest in them. Its not guaranteed they will over a given period, that’s the risk

Same concept applies for a basket of riskier small cap and value stocks

[rkhusky]

SCV is not an equity risk factor. Factor theory holds that the value factor and size factor are systematic risk factors that the market will compensate through additional expected return.

It’s more like the value and size factors have been compensated in the past. Not sure if there is any theory that says they will be compensated in the future.

Can be re-worded as: The equity risk premium has been compensated in the past. Not sure if there is any theory that says they will be compensated for in the future.

Stocks vs bonds is a strawman when comparing different shades of stocks.

Not at all

Stocks are priced with a higher expected value over risk free bonds, otherwise nobody would invest in them. Its not guaranteed they will over a given period, that’s the risk

Same concept applies for a basket of riskier small cap and value stocks

Are small value stocks really riskier than other types of stocks? Stocks vs bonds is easy to see, based on fundamental differences between the two.

[Nathan Drake]

It’s more like the value and size factors have been compensated in the past. Not sure if there is any theory that says they will be compensated in the future.

Can be re-worded as: The equity risk premium has been compensated in the past. Not sure if there is any theory that says they will be compensated for in the future.

Stocks vs bonds is a strawman when comparing different shades of stocks.

Not at all

Stocks are priced with a higher expected value over risk free bonds, otherwise nobody would invest in them. Its not guaranteed they will over a given period, that’s the risk

Same concept applies for a basket of riskier small cap and value stocks

Are small value stocks really riskier than other types of stocks? Stocks vs bonds is easy to see, based on fundamental differences between the two.

Yes, quantitatively they have higher volatility and larger drawdowns than the market

[Northern Flicker]

SCV is not an equity risk factor. Factor theory holds that the value factor and size factor are systematic risk factors that the market will compensate through additional expected return.

It’s more like the value and size factors have been compensated in the past. Not sure if there is any theory that says they will be compensated in the future.

Can be re-worded as: The equity risk premium has been compensated in the past. Not sure if there is any theory that says they will be compensated for in the future.

Of course the theory says EXPECTED returns adding in small and value will be higher than the market alone in the future. The theory says nothing about actual returns as there is too much uncertainty in the world.

EXPECTED returns are very different than actual returns.

That is a specious argument, as it is true for any investment that has risk. If there were no uncertainty of actual return, there would not even be a risk premium to be discounted in.

[Northern Flicker]

It’s more like the value and size factors have been compensated in the past. Not sure if there is any theory that says they will be compensated in the future.

Can be re-worded as: The equity risk premium has been compensated in the past. Not sure if there is any theory that says they will be compensated for in the future.

Stocks vs bonds is a strawman when comparing different shades of stocks.

Not at all

Stocks are priced with a higher expected value over risk free bonds, otherwise nobody would invest in them. Its not guaranteed they will over a given period, that’s the risk

Same concept applies for a basket of riskier small cap and value stocks

Are small value stocks really riskier than other types of stocks? Stocks vs bonds is easy to see, based on fundamental differences between the two.

One of the smallest stocks in the S&P 600 SCV is Avid Bioservices (CDMO). Here is a comparison with Microsoft:

https://www.portfoliovisualizer.com/bac ... lDV7o6t11d

I assume it was a small growth stock until things became challenging, and the market started discounting in steeper risk premia, sending it deep into the value space.

Warren Buffett started out as a deep value investor, buying downtrodden companies with quality management that he felt had a good chance of leading them to a turnaround. He calls this a cigar butt strategy.

In the smallcap and microcap space, many value stocks are distressed companies. Many will not turn around, but spectacular returns are possible for those that do. It may not be very many, so that an SCV fund is basically buying the whole haystack ashtray.

With quality screens and profitability screens, SCV funds are not as bleak as that sounds, filled with distressed companies circling the drain, but the principle applies.

By comparison, I think large cap value stocks are more a play on stocks with a more stable than average revenue stream, and thus are a play on a shorter expected duration. If a large cap company experiences distress, it will struggle to stay a large cap company.

This leads to one critique I have of factor theory-- I'm not convinced that the value factor is measuring the same thing for large and small stocks. This may be why it does not fit the multilinear factor model well.

I should add that the above is my opinion, and is based on my general observations. I don't claim it is correct. It probably is not what you will read from authors who are equity factor experts.

[BitTooAggressive]

SCV is not an equity risk factor. Factor theory holds that the value factor and size factor are systematic risk factors that the market will compensate through additional expected return.

It’s more like the value and size factors have been compensated in the past. Not sure if there is any theory that says they will be compensated in the future.

Can be re-worded as: The equity risk premium has been compensated in the past. Not sure if there is any theory that says they will be compensated for in the future.

Of course the theory says EXPECTED returns adding in small and value will be higher than the market alone in the future. The theory says nothing about actual returns as there is too much uncertainty in the world.

EXPECTED returns are very different than actual returns.

That is a specious argument, as it is true for any investment that has risk. If there were no uncertainty of actual return, there would not even be a risk premium to be discounted in.

It’s not an argument it’s a statement about being careful in our terminology. You may understand when someone is talking about returns and expected returns but someone else might not, especially someone new to investing. It can lead to much confusion for them and others.

Edit: someone new to investing may think oh small cap value has higher returns or high yield bonds has higher returns I want that. However thy don’t understand those are expected but you may and likely will get something different and those investments have higher risks.

[rkhusky]

Can be re-worded as: The equity risk premium has been compensated in the past. Not sure if there is any theory that says they will be compensated for in the future.

Stocks vs bonds is a strawman when comparing different shades of stocks.

Not at all

Stocks are priced with a higher expected value over risk free bonds, otherwise nobody would invest in them. Its not guaranteed they will over a given period, that’s the risk

Same concept applies for a basket of riskier small cap and value stocks

Are small value stocks really riskier than other types of stocks? Stocks vs bonds is easy to see, based on fundamental differences between the two.

Yes, quantitatively they have higher volatility and larger drawdowns than the market

The differences are so slight that it's doubtful that there is much difference in risk on average. In fact, Vanguard's Growth fund has had a higher SD than its Value fund (16.5% vs 15%), and the same is true for its Small Growth fund versus its Small Value fund (20.4% vs 19.3%). The 500 Index fund has had a smaller SD than the Small Cap Index fund (15.3% vs 19.6%). But the differences are orders of magnitude smaller than when comparing the SD of stocks vs bonds (15.3% vs 4.2%).

If we look at max drawdowns, then Small Cap Index is greater than 500 Index (54% vs 51%), Value is greater than Growth (55% vs 54%) and Small Value is greater than Small Growth (56% vs 54%). But stocks have had much greater max drawdowns compared to bonds (51% vs 18%).

So, using stocks vs bonds as a defense for growth vs value, and even large vs small, is a strawman argument.

[rkhusky]

Are small value stocks really riskier than other types of stocks? Stocks vs bonds is easy to see, based on fundamental differences between the two.

One of the smallest stocks in the S&P 600 SCV is Avid Bioservices (CDMO). Here is a comparison with Microsoft:

https://www.portfoliovisualizer.com/bac ... lDV7o6t11d

I assume it was a small growth stock until things became challenging, and the market started discounting in steeper risk premia, sending it deep into the value space.

Warren Buffett started out as a deep value investor, buying downtrodden companies with quality management that he felt had a good chance of leading them to a turnaround. He calls this a cigar butt strategy.

In the smallcap and microcap space, many value stocks are distressed companies. Many will not turn around, but spectacular returns are possible for those that do. It may not be very many, so that an SCV fund is basically buying the whole haystack ashtray.

With quality screens and profitability screens, SCV funds are not as bleak as that sounds, filled with distressed companies circling the drain, but the principle applies.

By comparison, I think large cap value stocks are more a play on stocks with a more stable than average revenue stream, and thus are a play on a shorter expected duration. If a large cap company experiences distress, it will struggle to stay a large cap company.

This leads to one critique I have of factor theory-- I'm not convinced that the value factor is measuring the same thing for large and small stocks. This may be why it does not fit the multilinear factor model well.

I should add that the above is my opinion, and is based on my general observations. I don't claim it is correct. It probably is not what you will read from authors who are equity factor experts.

Sure, you can get a dramatic effect when comparing a small company that has lost more than 90% of its value versus a hugely successful large company. But there are probably other cases where you can compare a small company that has done really well with a large company that has struggled.

[Northern Flicker]

But the probability of a SCV company going bankrupt or tanking severely is much greater than for a large cap company. There is a reason the market is pricing the projected future revenue stream of a SCV company more cheaply, and that is because collectively the market believes there is a lower probability of the revenue stream materializing than for a company with projected future revenue stream more expensive.

If you do not believe or agree with this, either you don't believe the market is efficient, or would consider SCV to be a free lunch.

Anyone who has invested in a SCV fund will tell you that the investor needs to have significant risk tolerance to stay the course through the high volatility of the fund, moreso than for a total market fund.

[Northern Flicker]

It’s more like the value and size factors have been compensated in the past. Not sure if there is any theory that says they will be compensated in the future.

Can be re-worded as: The equity risk premium has been compensated in the past. Not sure if there is any theory that says they will be compensated for in the future.

Of course the theory says EXPECTED returns adding in small and value will be higher than the market alone in the future. The theory says nothing about actual returns as there is too much uncertainty in the world.

EXPECTED returns are very different than actual returns.

That is a specious argument, as it is true for any investment that has risk. If there were no uncertainty of actual return, there would not even be a risk premium to be discounted in.

It’s not an argument it’s a statement about being careful in our terminology. You may understand when someone is talking about returns and expected returns but someone else might not, especially someone new to investing. It can lead to much confusion for them and others.

This is true for any stock investment, but a significant factor tilt can be very challenging for a new investor.

But I agree with your point. There are posts on BH that use the term expected return in ways suggestive that the author has a misunderstanding of what it means. It is not defined as "what you can expect", but is a mathematical concept.

[rkhusky]

But the probability of a SCV company going bankrupt or tanking severely is much greater than for a large cap company. There is a reason the market is pricing the projected future revenue stream of a SCV company more cheaply, and that is because collectively the market believes there is a lower probability of the revenue stream materializing than for a company with projected future revenue stream more expensive.

If you do not believe or agree with this, either you don't believe the market is efficient, or would consider SCV to be a free lunch.

Anyone who has invested in a SCV fund will tell you that the investor needs to have significant risk tolerance to stay the course through the high volatility of the fund, moreso than for a total market fund.

So, the lower price compensates the investor for the lower probability of future earnings, such that the lower price and lower probability roughly cancel and the expected return remains constant. We see that playing out with value and growth taking turns out-performing.

[Northern Flicker]

I don't know where Paul Merriman stands on this, but yes, many factor theorists believe that SCV stocks offer a higher expected return than the market portfolio as fair compensation for their commensurately higher risk.

[Nathan Drake]

But the probability of a SCV company going bankrupt or tanking severely is much greater than for a large cap company. There is a reason the market is pricing the projected future revenue stream of a SCV company more cheaply, and that is because collectively the market believes there is a lower probability of the revenue stream materializing than for a company with projected future revenue stream more expensive.

If you do not believe or agree with this, either you don't believe the market is efficient, or would consider SCV to be a free lunch.

Anyone who has invested in a SCV fund will tell you that the investor needs to have significant risk tolerance to stay the course through the high volatility of the fund, moreso than for a total market fund.

So, the lower price compensates the investor for the lower probability of future earnings, such that the lower price and lower probability roughly cancel and the expected return remains constant. We see that playing out with value and growth taking turns out-performing.

They don’t take turns and end up at neutral; value outperforms 80% of the time with a significant premium

[rkhusky]

But the probability of a SCV company going bankrupt or tanking severely is much greater than for a large cap company. There is a reason the market is pricing the projected future revenue stream of a SCV company more cheaply, and that is because collectively the market believes there is a lower probability of the revenue stream materializing than for a company with projected future revenue stream more expensive.

If you do not believe or agree with this, either you don't believe the market is efficient, or would consider SCV to be a free lunch.

Anyone who has invested in a SCV fund will tell you that the investor needs to have significant risk tolerance to stay the course through the high volatility of the fund, moreso than for a total market fund.

So, the lower price compensates the investor for the lower probability of future earnings, such that the lower price and lower probability roughly cancel and the expected return remains constant. We see that playing out with value and growth taking turns out-performing.

They don’t take turns and end up at neutral; value outperforms 80% of the time with a significant premium

That was in the distant past. Not relevant to today’s market or the future.

[rcmoormt]

Slightly off topic, but what is everyone's feelings about AVEE replacing AVES as the preferred EM SCV proxy? It doesn't have value in the name, but the tilts are all there. I'm not sure what stopped them from calling it SCV honestly.

[rkhusky]

I don't know where Paul Merriman stands on this, but yes, many factor theorists believe that SCV stocks offer a higher expected return than the market portfolio as fair compensation for their commensurately higher risk.

I’m not seeing higher risk compared to SCG for Vanguard’s funds over the last 25 years. Also not seeing higher risk for Value compared to Growth over the last 30 years. (All since fund inception)