Dimensional vs. Indexing
Re-posted from Swedroe: Value Premium Lives!
There has been much debate about the “death” of the value premium. Those making the case it has disappeared believe the publication of research on the premium has led to cash flows, which in turn have eliminated it.
They point to the last 10 calendar years of data, during which the value premium was slightly negative, at -0.8%. The value premium (HML, or high minus low) is the annual average return on high book-to-market ratio (value) stocks minus the annual average return on low book-to-market ratio (growth) stocks.
Before taking a deeper dive into the data, it’s important to note that all factor premiums, including market beta, have experienced long periods of negative returns. The following table, covering the period 1927 through 2017, shows the odds (expressed as a percentage) of a negative premium over a given time frame. Data in the table is from the Fama/French Data Library.
No matter the horizon, the value premium has been almost as persistent as the market beta premium. Even the market beta premium has been negative in 9% of 10-year periods and in 3% of 20-year periods.
Investors who know their financial history understand that what we might call “regime change,” with value underperforming for a fairly long time, is to be expected. In fact, even though the value premium has been quite large and persistent over the long term, it has been highly volatile. According to Ken French’s data, the annual standard deviation of the premium, at 12.9%, is 2.6 times the size of the 4.8% annual premium itself (for the period 1927 through 2017).
While 10 years may seem like an eternity to most investors (even institutional investors fire managers after a few years of underperformance), it can be nothing more than noise. Having to remain disciplined over such long periods is perhaps why Warren Buffett famously said that investing is simple, but not easy.
As Andrew Berkin and I point out in our book, “Your Complete Guide to Factor-Based Investing,” investors should have confidence in the value premium because it has been persistent across long periods of time and various economic regimes and has been pervasive around the globe and across asset classes. In addition to stocks, a value premium has existed in bonds, commodities and currencies (in other words, buying what is cheap has outperformed buying what is expensive).
Furthermore, the value premium has been robust to various definitions, not just the price-to-book (P/B) measure, or HML, popularized by Fama and French. Indeed, the premium is also found when using other value metrics, such as price-to-earnings (P/E), price-to-cash flow (P/CF), price-to sales (P/S), price-to-earnings before interest, taxes, depreciation and amortization (P/EBITDA), price-to-dividend (P/D) and price to almost anything—however it’s measured, cheap has outperformed expensive.
With that in mind, we can look at the size of the value premium for the 10-year period ending 2017 against some of those other metrics (all data is from Ken French’s website). While the value premium was negative by P/CF (-1.2%) and slightly negative by P/B, it was actually positive using P/E (1.2%) and P/D (0.6%)—so, on average, about zero.
Before moving on, it’s important to note many have questioned the sole use of P/B as the best value metric, especially in an age when many assets are now intellectual capital that often don’t appear on balance sheets (externally acquired intangibles do appear on balance sheets).
Reasons not to believe P/B—or for that matter, any single metric—is the superior measure of value include the fact that one metric could work better than others do for some industries, and various metrics have provided the highest premium in different economic regimes. That is why many practitioners and mutual fund families now use multiple metrics, which I believe can provide a diversification benefit.
Having covered that ground, let’s go to our trusty videotape and see how value performed outside the U.S. If value is “dead,” we should find confirming evidence in other markets.
The following table—again, using data from Ken French’s website—shows the premium for the 10 years from 2008 through 2017 in international developed markets.
|2008-2017||Average Annual Premium (%)|
No matter which metric I use, there was a value premium in developed international markets. This result actually surprised me, because research shows value stocks are more exposed to economic cycle risks—they perform best in periods of stronger economic growth because they become less risky. While the last 10 years saw the slowest economic recovery in the post-World War II era, economic growth has been even more anemic in the non-U.S. developed world.
Having shown the value premium in international markets has been fairly similar to historical levels, I can also examine live results.
Specifically, I’ll compare the returns of the passively managed, structured international value funds my firm uses with those of marketlike ETFs in three asset classes. Data is from Morningstar and covers the 10-year period ending May 4, 2018. (Full disclosure: My firm, Buckingham Strategic Wealth, recommends Dimensional funds in constructing client portfolios.)
|iShares MSCI EAFE ETF (EFA)||2.25%|
|DFA International Value Portfolio III (DFVIX)||2.20%|
|iShares MSCI EAFE Small-Cap ETF (SCZ)||6.05%|
|DFA International Small Value (DISVX)||5.89%|
|iShares MSCI Emerging Markets ETF (EEM)||1.29%|
|DFA Emerging Markets Value (DFEVX)||1.66%|
Note: Dimensional’s international strategies include Canada; EAFE indexes do not.
The average return of the three ETFs was 3.20%. The average return of the three Dimensional value funds was 3.25%. Thus, while there was a value premium, compound returns were no better (as the roughly 2-3% higher annual volatility of value stocks negatively affected their compound returns), but no worse, either.
One way to look at the results is that, over one of the worst 10-year periods for the performance of value stocks, value investors were not “penalized” for their strategic decisions. Another is to believe the value premium is dead.
My view is that there is a large body of evidence demonstrating logical, risk-based explanations for the value premium. While cash flows can shrink premiums, risk-based premiums cannot be arbitraged away. On the other hand, it’s possible to arbitrage away behavioral-based premiums, such as momentum (though limits to arbitrage often prevent this from occurring).
Among the risk-based explanations for the premium are that value stocks contain a distress (default) factor, have more irreversible capital, have higher volatility of earnings and dividends, are much riskier than growth stocks in bad economic times, have higher uncertainty of cash flow, and, as previously mentioned, are more sensitive to bad economic news.
Given these risk-based explanations, it is hard to believe the value premium can be arbitraged away. With that understanding, let’s consider whether cash flows have eliminated the premium.
If, as many people believe, the publication of findings on the value premium has led to cash flows that have caused it to disappear, we should have seen massive outperformance in value stocks as investors purchased those equities and sold growth stocks.
Yet the last 10 years have witnessed the reverse in terms of performance. In addition, if cash flows had eliminated the premium, the buying of “undervalued” value stocks and selling of “overvalued” growth stocks should have led to a reduction in the valuation spreads between value stocks and growth stocks.
I happen to have kept a table from a seminar Dimensional gave in 2000. It shows that, at the end of 1994, the P/B ratio of large growth stocks was 2.1 times as big as the P/B ratio of large value stocks.
Using Morningstar data, as of May 3, 2018, the iShares S&P 500 Growth ETF (IVW) had a P/B ratio of 4.7, and the iShares S&P 500 Value ETF (IVE) had a P/B ratio of just 2.0—the spread has actually widened from 2.1 to 2.4. Thus, value stocks are cheaper today, relative to growth stocks, than they were shortly after Fama and French published their famous research.
We can also look at the P/E metric. In 1994, according to the Dimensional table, the ratio of the P/E in large growth stocks relative to the P/E in large value stocks was 1.5. As of May 3, 2018, and again using Morningstar data, IVW had a P/E ratio of 20.0, and IVE had a P/E ratio 14.4. Thus, the ratio, at 1.4, was almost unchanged. There’s no evidence here that cash flows have eliminated the premium.
We see similar results when we look at small stocks. The Dimensional data shows that, at the end of 1994, the P/B of the CRSP 9-10 (microcaps) was 1.5 times as large as the P/B of small value stocks. Using Dimensional data, and the firm’s microcap fund (DFSCX) for microcaps and its small value fund (DFSVX) for small value stocks, as of April 30, 2018, the ratio of the funds’ respective P/B metrics was the same 1.5 (1.9÷1.3). When we look at P/E, again, the results are similar. At the end of 1994, the ratio of those funds’ respective P/E metrics was 1.2; it is now the same 1.2 (20.2÷16.3). Again, I see no evidence that cash flows have eliminated the premium.
Using data from Ken French’s website, we also see similar results when we look at the period starting in 2008. In 2008, the ratio of the P/B of U.S. growth stocks (4.8) to U.S. value stocks (1.1) was 4.4. By the end of 2017, the ratio had increased to 5.3 (6.3÷1.2), the opposite of what you would expect if cash flows had eliminated the premium.
Based on the logical, risk-based explanations for the value premium, and the lack of evidence pointing to shrinking valuation spreads, my conclusion is that the most recent 10 years of performance is likely just another of those occasionally occurring but fairly long periods in which the value premium is negative. If periods such as these did not occur, there would be no risk, and no risk premium. This is true of all risky investments, including stocks (and thus the market beta premium).
The bottom line is that, at least in my opinion, it’s hard to conclude the value premium is dead. Being able to stay the course during long periods of relative underperformance is what led Warren Buffett to assert that successful investing has a lot more to do with temperament (meaning discipline and patience) than intellect.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.
Reposted from http://www.investmentnews.com
With its data-driven models the company attracted third-most money in 2014 behind Vanguard and JPMorgan
Jan 19, 2015 @ 9:14 am
By Bloomberg News
When Molly Bernet Balunek expressed interest in putting money into mutual funds run by Dimensional Fund Advisors, she didn’t know she was in for a rigorous courtship ritual.
Before getting the go-ahead to invest in Dimensional’s products last year, Ms. Balunek, a financial adviser from Cleveland, had to submit to an interview, fill out a questionnaire and pay out of her own pocket for a two-day trip to Austin, Texas, where she listened to the company’s executives explain how they do business. The process, which Ms. Balunek described as “intense,” took about five months.
“It is a two-way evaluation process — Dimensional wanted to understand my business structure and investment philosophy as much as I wanted to understand theirs,” said Ms. Balunek.
The ritual is part of a sales process that has helped Dimensional attract the third-most money last year after Vanguard Group Inc., known for its low-cost index funds, and JPMorgan Chase & Co. Like Vanguard,
Dimensional is capitalizing on a growing belief that stock pickers can’t consistently beat markets. Dimensional’s approach, though, comes with a twist: unlike traditional index strategies, the funds use data-driven models to beat traditional benchmarks.
Dimensional is among a small group of managers toppling the dominance of firms such as Fidelity Investments and Capital Group, which have built their reputations on picking individual stocks. Among the fastest-growing U.S. mutual fund firms after assets surged almost six-fold in the past decade, Dimensional attracted almost $28 billion in new money in 2014.
Dimensional believes beating the markets is an exercise in futility and most managers cannot justify the fees they charge. What sets Dimensional apart is its investment philosophy, using research pioneered by Nobel laureate Eugene Fama and Kenneth French, of focusing on specific factors or dimensions that have helped certain indexes beat benchmarks such as the S&P 500 Index.
Dimensional, which sells its funds only through approved advisers and never directly to the public, spends considerable effort educating investors on how its approach works. Its system of picking advisers breeds a high degree of loyalty. The firm received the highest grades in customer loyalty among mutual fund companies in a July 2014 survey of U.S. financial advisers conducted by Cogent Reports of Cambridge, Mass.
“They’ve developed a brilliant way of locking in money and the advisers who use them seem to love it,” said Lawrence Glazer, a managing partner at Mayflower Advisors, a Boston-based adviser that oversees $2 billion.
David Butler, who runs Dimensional’s financial adviser business, said he could “count on one hand,” the advisers who have stopped using the company’s funds in his nearly 20 years at the company.
Advisers who use Dimensional, “tend to buy into the firm’s unique philosophy and investment approach and direct a higher proportion of their mutual fund dollars to the firm,” Linda York, a Cogent vice president, wrote in an e-mail.
Dimensional’s assets have more than doubled since 2009 to $381 billion in a mix of mutual funds and institutional accounts. Part of the growth is the result of shifting client sentiment, as investors disillusioned with the ability of stock pickers to insulate them from losses during the 2008 crisis have increasingly turned to cheaper alternatives such as index mutual funds and exchange-traded funds.
Mutual funds that pick U.S. stocks experienced $98 billion in redemptions in 2014. During the same period, investors added $167 billion to domestic stock index funds and ETFs, according to data from Chicago-based Morningstar Inc.
Vanguard attracted $219 billion in mutual fund and ETF deposits last year. Fidelity had redemptions of $5.3 billion while American Funds, the mutual fund arm of Capital Group, won $345 million.
Mayflower’s Mr. Glazer said while low-cost indexing is popular at the moment, there is no guarantee it will remain so.
“If the history of asset management is any guide, the companies and styles that were the leaders in one decade, won’t be the leaders in the next decade.”
“Conventional active managers promised a lot that they weren’t able to deliver,” David Booth, 68, chairman and co-founder of Dimensional, said in an interview at his company’s headquarters in Austin.
Mr. Booth built his firm around the ideas of his University of Chicago mentor Mr. Fama, who won the 2013 Nobel Prize in economics for his work on efficient markets. In 2008, crediting the school for his success, Mr. Booth donated $300 million to his alma mater, which renamed its business school the University of Chicago Booth School of Business.
Mr. Fama and his research partner, Dartmouth College’s Mr. French, have argued that stock-price movements are unpredictable and that trying to pick securities that will beat the market is pointless.
“Most people are fooling themselves when they think they have the ability to hire a superior manager,” said Mr. French, in a video posted on Dimensional’s website.
The pair’s research also shows that certain factors can produce higher returns. Using historical market data, they found that over the long term, small stocks have outperformed large ones, value-oriented equities have beaten growth and more profitable companies have done better than less profitable peers. Dimensional’s funds reflect those tilts, with portfolios composed of small-cap companies, value shares and stocks of companies with above-average profits.
Over the past five, 10 and 15 years, Dimensional’s stock funds have outperformed about 70% of peers, according to Denver-based Lipper. Bond funds, a smaller piece of the business, trailed about 60%. Over the past 15 years, almost 90% of the company’s stock and bond strategies with a track record that long have topped their benchmarks, Dimensional data show.
Dimensional executives say that they can’t quantify or guarantee the amount of outperformance they can generate.
“If we can beat the benchmarks by 50 basis points a year — and in many strategies by 100 basis points — I will do handstands,” said Mr. Booth.
For the last 15 years, Dimensional’s funds have benefited from a rally in small-capitalization and value shares. Since the end of 1999, small stocks, as measured by the Russell 2000, have returned more than twice as much as large stocks, represented by the S&P 500 Index. Value stocks gained about four times as much as growth stocks.
The opposite pattern prevailed during the technology boom of the late 1990s, as big stocks and growth stocks outperformed, data compiled by Bloomberg show. In 2014, small cap stocks lagged behind large ones by a wide margin. They trailed again in 2015 through Jan. 13.
William Smead, a stock picker who runs the $952 million Smead Value Fund and invests in big companies, said if historical patterns hold, small cap stocks could lag behind large ones for the next six to nine years.
Setting realistic expectations for performance is just one piece of Dimensional’s close relationship with advisers, a relationship that began as an accident, according to Mr. Booth.
In the 1980s, the firm managed money exclusively for institutional investors. In 1988, an adviser approached Mr. Booth about investing in Dimensional funds.
The idea was intriguing and also somewhat disturbing, said Mr. Booth, who was concerned that advisers would move in and out of the funds too often, burdening other investors with higher costs. Minimizing trading costs is part of Dimensional’s plan for adding value. The solution was to create a system in which the company could pick advisers who bought into Dimensional’s approach and played by its rules.
“They don’t want advisers who are traders, they don’t want hot money and they don’t want people who are chasing performance,” said Ms. Balunek, who described the process of becoming a Dimensional adviser as more “invasive” than she anticipated.
Mr. Booth said the extended process — including having advisers pay their own way to the introductory seminar — has paid dividends.
“We have made it kind of a pain in the neck to buy the funds, but that has created a mutual affinity.”
Bob Rall, an adviser from Merritt Island, Fla., can speak to that affinity. He started out with a firm that tried to pick individual securities and said he got tired of client losses because of bad stock picks.
He found out about Dimensional 12 years ago and attended one of their conferences. Mr. Rall now has about 90% of the $35 million he oversees invested in Dimensional funds.
“They poured us big glasses of Kool-Aid, we drank it and haven’t looked back,” he said.
Advisers are also attracted to the credentials of the academics behind Dimensional’s investing and trading strategies. In addition to Mr. Fama and Mr. French, Nobel Prize winner Robert Merton of Massachusetts Institute of Technology is involved in designing products for the company.
Having advisers that believe in the firm creates another benefit for Dimensional and its customers, according to Michael Rosen, chief investment officer at Angeles Investment Advisors in Santa Monica, Calif., who oversees $45 billion for endowments and pensions.
“Educated advisers are more likely to prevent their clients from making radical changes when markets drop,” said Mr. Rosen. “The fact that those assets are sticky will add value for the investors.”
Dimensional’s approach to markets, with its tilts toward small and value stocks, at one time made it distinct in the money-management business, said Alex Bryan, an analyst with Morningstar. Many firms are now competing in the same arena including AQR Capital Management, he said, and products such as low-cost ETFs are also vying for investor capital.
“Investors have a lot of options now,” said Mr. Bryan. “They don’t have to go to Dimensional to get exposure to those strategies.”
Mr. Booth isn’t worried by the competition. He has invested in systems that will allow the firm to grow, although he refrains from projecting how big it might get. When the company passed $50 billion in assets in 2004, he said, “It was already bigger than we thought it could possibly be.”
Mr. Booth, who owns Dimensional along with other past and current employees and directors, doesn’t see that changing anytime soon. He said he has turned down repeated requests to sell Dimensional or take it public.
“The next generation of leadership is in place and they will worry about firm ownership,” said Mr. Booth. “For the time being we are ignoring the fact that we are getting older. This is what we want to be doing.”