Small Cap Value: Diversification or Di-Worse-Fication?

[exodusing]

Your post appears to suggest a portfolio that's generally better than the market portfolio. If such a portfolio existed, why hasn't the market moved there? This does seem contrary to efficient markets.

I agree with you way more than you might think. I’m a big believer in market efficiency. In fact I’m pretty sure Fama states that TSM is always on the efficient frontier, and I think I’ve heard Larry Swedroe say that too. The only way I’ve been able to reconcile this in my mind is to distinguish between an efficient market and an efficient portfolio. Markowitz got a Nobel prize for Modern Portfolio Theory, and books like Roger Gibson’s Asset Allocation: Balancing Financial Risk and Larry Swedroe’s Reducing The Risk Of Black Swans show that combining low correlated assets in a portfolio make for more efficient portfolios. Gibson shows this by displaying how mixtures of uncorrelated assets move the potential outcomes of portfolios closer to the ideal northwest corner of a plot of return versus standard deviation. Larry shows this with potential portfolio outcomes that have same expected return but narrower standard deviations and smaller tails. In our portfolios, TSM is only one portfolio component. Adding other components with similar expected return and less than perfect correlation has a good chance of having created a more efficient portfolio when looking backwards at one’s investing results.

Dave

The average investor (where average is weighted by portfolio size) has no doubt considered correlations (and valuations and expectations and etc., etc.). The result of this has been the market portfolio. As above, Ken French's average invested dollar might be clearer. It's hard to believe that there's a major market participant which has not considered issues of portfolio construction.

MPT has essentially been superseded. The underlying insight (risk v. expected return) continues, but single factor, single time frame, simplistic definition of risk are just parts of a highly stylized model. See, for example, John Cochrane's https://www.johnhcochrane.com/research- ... ctor-world Larry, for all his virtues, is a fan of highly engineered portfolios which tend to have issues.

BTW, TSM is only one component of the market portfolio.

[RiskAnalyst]

Merriman's chart is tendentious, with extra lines on it that are intended to make you see it in a certain way.

Which 'extra' lines are you referring to?

The superimposed trend lines are at best misleading, since they are upward sloping during the labeled periods of outperformance and flat (not downward sloping, despite the legend) during the labeled periods of underperformance. This visually implies less volatility in relative performance, and thus less risk to tilting. This is irrespective of the choice of start/end points for the labeled periods.

[Random Walker]

MPT has essentially been superseded. The underlying insight (risk v. expected return) continues, but single factor, single time frame, simplistic definition of risk are just parts of a highly stylized model.

I agree that there are other definitions/dimensions of risk not encompassed by volatility. But I don’t think they take away from the basic MPT finding of the benefits of mixing low correlated assets. In fact, knowing there are different dimensions of risk, makes me perhaps naively more adamantly adhere to a portfolio based on MPT.

Dave

[Kendall]

A snarky exchange has been removed. As a reminder, see General Etiquette

At all times we must conduct ourselves in a respectful manner to other posters. Attacks on individuals, insults, name calling, trolling, baiting or other attempts to sow dissension are not acceptable.

[exodusing]

MPT has essentially been superseded. The underlying insight (risk v. expected return) continues, but single factor, single time frame, simplistic definition of risk are just parts of a highly stylized model.

I agree that there are other definitions/dimensions of risk not encompassed by volatility. But I don’t think they take away from the basic MPT finding of the benefits of mixing low correlated assets. In fact, knowing there are different dimensions of risk, makes me perhaps naively more adamantly adhere to a portfolio based on MPT.

Dave

Agreed. The point is that there does not appear to be a good reason to believe the market hasn't "considered" those issues and come up a portfolio with an appropriate mix of uncorrelated assets - the market portfolio.

It can not be the case that it's a good idea for everyone to tilt in the same direction if markets are at all efficient or rational.

The linked paper is well worth reading, including the conclusion (spoiler - it agrees with the approach Ken French and I are suggesting). It's a good background on advances since Markowitz.

[incognito_man]

Is anyone aware of where one might find historical data for VSCIX benchmark that goes back earlier than 1997? Thanks!

[Chocolatebar]

Which 'extra' lines are you referring to?

The superimposed trend lines are at best misleading, since they are upward sloping during the labeled periods of outperformance and flat (not downward sloping, despite the legend) during the labeled periods of underperformance. This visually implies less volatility in relative performance, and thus less risk to tilting. This is irrespective of the choice of start/end points for the labeled periods.

I suppose so. Feel free to imagine downward-sloping lines instead of flat ones — the facts will remain unchanged either way.

[rkhusky]

The superimposed trend lines are at best misleading, since they are upward sloping during the labeled periods of outperformance and flat (not downward sloping, despite the legend) during the labeled periods of underperformance. This visually implies less volatility in relative performance, and thus less risk to tilting. This is irrespective of the choice of start/end points for the labeled periods.

I suppose so. Feel free to imagine downward-sloping lines instead of flat ones — the facts will remain unchanged either way.

Or add more up and down lines and change some of the end points. I’m also not sure of the relevancy of the pre-90’s data to the future markets, what with the implementation of the WWW and publication of the initial FF paper in the mid-90’s.

[Beensabu]

Nope, just doing my part to correct misinformation and redefinitions of common terms.

[GP813]

Avantis has a bunch of screens for profitability and quality, so the fundamentals of the portfolios they make tend to be very good.

So, the best of the junky stocks, if their metrics pan out.

The market knows everything Avantis knows about quality and profitability factors, so it’s not clear why those stocks aren’t quickly bid up to erase any easy profits.

What is a "junky" stock?

This fund AVUV is made of of U.S. small cap value, not small cap growth. Maybe you are confusing your factors. People often overlook value for growth and that speculation is driven by simple greed. So the market which is made up of people's decisions is not perfect in pricing even when all available information is known. During the pandemic Zoom was worth more than Exxon Mobil.


Value stocks can underperform for a long time but eventually their fundamentals shine through. The last 10 years a lot of investors have been buying stories and projections and they've been rewarded for that. I myself have bought some of these companies but eventually that stalls and people will reach for quality and value again.

All the companies in AVUV are known, you can look them up, it's a broad section of the U.S. economy's small cap value companies in nearly every industry you can think of, so hardly junk.

[exodusing]

So, the best of the junky stocks, if their metrics pan out.

The market knows everything Avantis knows about quality and profitability factors, so it’s not clear why those stocks aren’t quickly bid up to erase any easy profits.

What is a "junky" stock?

This fund AVUV is made of of U.S. small cap value, not small cap growth. Maybe you are confusing your factors. People often overlook value for growth and that speculation is driven by simple greed. So the market which is made up of people's decisions is not perfect in pricing even when all available information is known. During the pandemic Zoom was worth more than Exxon Mobil.


Value stocks can underperform for a long time but eventually their fundamentals shine through. The last 10 years a lot of investors have been buying stories and projections and they've been rewarded for that. I myself have bought some of these companies but eventually that stalls and people will reach for quality and value again.

All the companies in AVUV are known, you can look them up, it's a broad section of the U.S. economy's small cap value companies in nearly every industry you can think of, so hardly junk.

junky: value advocates often speak of value stocks in these terms - unloved, not glamorous, low growth prospects, etc. That's why they're cheap relative to book value - the market does not regard them as attractive.

simple greed: are buyers of value driven by altruism?

market ... is not perfect in pricing: the market doesn't have to be perfect. The question for investors is whether they are better at pricing stocks than the market price. Are you?

eventually fundamentals shine: remember the relation between risk and expected value and what that implies about any assurance about a bright future.

[GP813]

What is a "junky" stock?

This fund AVUV is made of of U.S. small cap value, not small cap growth. Maybe you are confusing your factors. People often overlook value for growth and that speculation is driven by simple greed. So the market which is made up of people's decisions is not perfect in pricing even when all available information is known. During the pandemic Zoom was worth more than Exxon Mobil.


Value stocks can underperform for a long time but eventually their fundamentals shine through. The last 10 years a lot of investors have been buying stories and projections and they've been rewarded for that. I myself have bought some of these companies but eventually that stalls and people will reach for quality and value again.

All the companies in AVUV are known, you can look them up, it's a broad section of the U.S. economy's small cap value companies in nearly every industry you can think of, so hardly junk.

junky: value advocates often speak of value stocks in these terms - unloved, not glamorous, low growth prospects, etc. That's why they're cheap relative to book value - the market does not regard them as attractive.

simple greed: are buyers of value driven by altruism?

market ... is not perfect in pricing: the market doesn't have to be perfect. The question for investors is whether they are better at pricing stocks than the market price. Are you?

eventually fundamentals shine: remember the relation between risk and expected value and what that implies about any assurance about a bright future.

Buyers of value are motivated by paying a fair price for future earnings. Buyers of growth are often motivated by overpaying for higher expected future earnings, sometimes they even overpay for outlandish scenarios because they so believe in the story. Sometimes the story pays off: Amazon(I invested in Amazon when it had never turned a profit because I believed in what they were building and luckily it worked out).

The market prices things irrationally all the time. I own index funds now because I am not better in the long run than the market but a rational person can still spot things that are out of whack or under or overvalued.

There's enough evidence that value does shine over time. DFA has shown this research as have Fama and French, the only problem is that people don't care because the S&P 500 has returned nearly 14% annually and QQQ returned nearly 19% annually before the recent downturn over the last fifteen years mostly driven by tech stocks.

[omedus82]

Don't say we didn't warn you: https://corporate.vanguard.com/content/ ... anged.html

Historical large cap PE ratio ~18 and SCV ~16. Right now it's 25 and 10. Massive spread. S&P500 has never gained >10% CAGR in the next 5 year period when starting at this high of a valuation and SCV has never returned <10% CAGR over the next 5 years when starting at this low of a valuation. I don't think this time is different. Let's see what happens.

Very good point and I am also patiently waiting for SCV to outperform. Mine is all IJS.

IJS used to be the preferred US SCV fund, but it has now faded. Everyone seems to be piling in to AVUV now. I think it is in part because of recency bias. Here are the trailing 5 year total returns:

AVUV +112.66%
VTI +97.52%
IJS +56.50%

One of the challenges of SCV funds is some SCV funds can outperform the total market while others underperform.

[exodusing]

junky: value advocates often speak of value stocks in these terms - unloved, not glamorous, low growth prospects, etc. That's why they're cheap relative to book value - the market does not regard them as attractive.

simple greed: are buyers of value driven by altruism?

market ... is not perfect in pricing: the market doesn't have to be perfect. The question for investors is whether they are better at pricing stocks than the market price. Are you?

eventually fundamentals shine: remember the relation between risk and expected value and what that implies about any assurance about a bright future.

Buyers of value are motivated by paying a fair price for future earnings. Buyers of growth are often motivated by overpaying for higher expected future earnings, sometimes they even overpay for outlandish scenarios because they so believe in the story. Sometimes the story pays off: Amazon(I invested in Amazon when it had never turned a profit because I believed in what they were building and luckily it worked out).

The market prices things irrationally all the time. I own index funds now because I am not better in the long run than the market but a rational person can still spot things that are out of whack or under or overvalued.

There's enough evidence that value does shine over time. DFA has shown this research as have Fama and French, the only problem is that people don't care because the S&P 500 has returned nearly 14% annually and QQQ returned nearly 19% annually before the recent downturn over the last fifteen years mostly driven by tech stocks.

Hard to judge motivations of others. I'd guess most want to pay a good price for future earnings.

The market may be irrational. Or not. The main way many judge the market is by reference to the market on other dates, which seems a bit circular. In any event, my question is whether you are better at pricing.

Value has outperformed growth over some periods and not others. All of this research is of the past and we don't have enough long-term reliable independent periods to have much confidence in predictions. Hard to say what will happen in the future.

[realclemsongrad]

Very good point and I am also patiently waiting for SCV to outperform. Mine is all IJS.

IJS used to be the preferred US SCV fund, but it has now faded. Everyone seems to be piling in to AVUV now. I think it is in part because of recency bias. Here are the trailing 5 year total returns:

AVUV +112.66%
VTI +97.52%
IJS +56.50%

One of the challenges of SCV funds is some SCV funds can outperform the total market while others underperform.

Thanks and I realized this as well. I am wondering why ADUV over performs IJS by a wide margin.

[jjj_22]

IJS used to be the preferred US SCV fund, but it has now faded. Everyone seems to be piling in to AVUV now. I think it is in part because of recency bias. Here are the trailing 5 year total returns:

AVUV +112.66%
VTI +97.52%
IJS +56.50%

One of the challenges of SCV funds is some SCV funds can outperform the total market while others underperform.

Thanks and I realized this as well. I am wondering why ADUV over performs IJS by a wide margin.

AVUV is generally smaller (lower market cap) and more value-y (lower p/e) than IJS and also includes quality/profitability screens.

IJS tracks an index.

[rkhusky]

So, the best of the junky stocks, if their metrics pan out.

The market knows everything Avantis knows about quality and profitability factors, so it’s not clear why those stocks aren’t quickly bid up to erase any easy profits.

What is a "junky" stock?

This fund AVUV is made of of U.S. small cap value, not small cap growth. Maybe you are confusing your factors. People often overlook value for growth and that speculation is driven by simple greed. So the market which is made up of people's decisions is not perfect in pricing even when all available information is known. During the pandemic Zoom was worth more than Exxon Mobil.


Value stocks can underperform for a long time but eventually their fundamentals shine through. The last 10 years a lot of investors have been buying stories and projections and they've been rewarded for that. I myself have bought some of these companies but eventually that stalls and people will reach for quality and value again.

All the companies in AVUV are known, you can look them up, it's a broad section of the U.S. economy's small cap value companies in nearly every industry you can think of, so hardly junk.

The new name for junk bonds is high yield bonds. Value stocks are the equivalent in the stock space.

The reason that the price is low for these stocks compared to other stocks with similar earnings and book value is that their fundamentals don’t look as good, ie there is more risk that value companies will be able to deliver their current and projected earnings. The market knows how to read balance sheets and the like in order to determine fundamentals.

If two companies are both earning $1/sh, but one is priced at $10/sh and the other is at $20/sh, there’s a reason for it. It’s the same with bonds, if one bond is paying 5% and another is paying 10% for the same duration, there’s a reason for it.

In times when the market is overly pessimistic about these value companies compared to what happens in the future, they will do well. In times when the market is too confident in these companies, they won’t do as well. Or they will do okay, but other market segments will do better.

[Glawen]

AVUV is a hair below VTI since inception despite the small and value factors providing negative returns since AVUV's inception (sept 2019).

Looking at the Ken French published 5 factor data, the average annual returns for each factor from 2020-2024 are:
Mkt-RF: 11.83
SMB: -1.43
HML: -2.11
RMW: 8.70
CMA: 0.42
RF: 1.72

Using the factor loading tool, we can see that the factor loading on AVUV during the same period (2020-2024) are:
Mkt-RF: 1.06
SMB: 0.84
HML: 0.61
RMW: 0.23
CMA: -0.14

This resulted in a higher return than over VTI during this period, whereas most SCV funds had a lower return than VTI duirng this period.

It looks like what is going on here is that despite AVUV having a stronger loading of the SMB and HML factors (which were both negative duringthis period) than other SCV funds, it also had a greater than 100% exposure to Mkt-RF equity return and to the RMW factor. Since the negative returns from small and value factors during this period were comparatively smaller than the positive returns of the Mkt-RF and RMW factors, the overall returns were essentially the same as VTI (and actually slightly outperformed during this period).

ie. if you multiply out the factor capture of AVUV times the performance of those factors, it ended up being about equal to the Mkt-RF for the whole market.

Other SCV, LCV, and multifactor funds usually had <= 1.0 exposure to Mkt-RF, and no statistically significant exposure to RMW during this period, which is why a simple SCV index ate it for the last few years, while AVUV held up!

This really lends support to the importance of the "profitability screen" that Eduardo Repeto talks about, and is a good case for why diversifying across factors is important.

[rkhusky]

This really lends support to the importance of the "profitability screen" that Eduardo Repeto talks about, and is a good case for why diversifying across factors is important.

Or that sometimes one little undiversified corner of the market does better than another little undiversified corner of the market, and also about the same as the market as a whole.

[3funder]

I stopped asking myself this question a long time ago. I never tilted, but I can't say I never considered it. Simplification has worked just fine for me.