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Do Implementation Costs Destroy Returns from Factor Portfolios?

Do factor premiums survive implementation costs? To answer this question, I’ll examine the returns of live mutual funds to see if they have been successful at capturing the returns of small-cap and value premiums.

As background, my book, Your Complete Guide to Factor-Based Investing, includes a checklist of criteria that should be met before you consider investing in a factor. For a factor to be considered, it must meet all of the following tests. To start, it must provide incremental explanatory power to portfolio returns and have delivered a premium (higher returns). Additionally, the factor must be:

  • Persistent – It holds across long periods of time and different economic regimes.
  • Pervasive – It holds across countries, regions, sectors and even asset classes.
  • Robust – It holds for various definitions (for example, there is a value premium, whether it is measured by price-to-book, earnings, cash flow or sales).
  • Investable – It holds up not just on paper but also after considering actual implementation issues, such as trading costs.
  • Intuitive – There are logical risk-based or behavioral-based explanations for its premium and why it should continue to exist.

This article focuses on the question of investability and implementation costs. We’ll begin by examining the size factor – a logical place to start because small-cap stocks are less liquid and thus potentially more expensive to trade. Is the size premium realizable – or does it just exist on paper? Let’s start by examining the returns of small-cap mutual funds.

We’ll begin by looking at the returns of the Bridgeway Ultra-Small Company Market Fund (BRSIX). This fund was chosen because it is passively managed (rules-based) and invests in the smallest of small-cap stocks (called “microcap” stocks), where trading costs are potentially a significant hurdle. The fund’s inception date was July 31, 1997. For the period August 1997 through June 2019, the fund returned 9.7%. (All fund returns data are from Portfolio Visualizer.) Despite its expense ratio (currently 0.86%), it outperformed the CRSP 9–10 Index (the bottom 20% of stocks ranked by market capitalization), which returned 9.6%. And it underperformed the CRSP 10 Index (the smallest 10% of stocks), which returned 9.9%, by just 0.2 percentage point. Keep in mind that indices have no costs, while any investment would incur not just a fund’s expense ratio but also trading costs.

As further evidence that returns to small-cap stocks can be captured by well-structured, passively managed funds, we can look at the returns of the DFA U.S. Micro Cap Portfolio (DFSCX), with a current expense ratio of 0.52%, and the DFA Small Cap Portfolio (DFSTX), with a current expense ratio of 0.37%. From inception in January 1982 through June 2019, DFSCX returned 10.6%, outperforming the CRSP 9–10 and CRSP 10 indices by 0.7 percentage point and 0.9 percentage point, respectively. From its inception in April 1992 through June 2019, DFSTX returned 10.3%, underperforming the CRSP 6-10 Index by 0.4% (basically its expense ratio).

Vanguard also has a small-cap index fund we can examine. NAESX, which currently has an expense ratio of 0.17% (the Admiral Shares version, VSMAX, has an expense ratio of just 0.05%), became an index fund in September 1989. The original benchmark index for the fund was the Russell 2000 Index. Due to issues with that index (which led to relatively poor performance compared to other small-cap indices), Vanguard eventually changed its benchmark, first to an MSCI index and eventually to a CRSP index. For the period September 1989 through June 2019, the fund returned 9.9%, outperforming the Russell 2000 Index (which returned 9.1%), but underperforming the CRSP 6–10 Index (which returned 10.5%). We can also examine the performance of Vanguard Small Cap ETF (VB), which has a current expense ratio of 0.05%. From February 2004 through June 2019, it returned 9.4%, outperforming the MSCI US Small Cap 1750 Index by 0.3 percentage point, and the CRSP 6-10 Index by 0.9 percentage point.

We can also examine the live returns of Dimensional’s international and emerging market small-cap funds in relation to the returns of comparable small-cap indices. From January 1999, the inception date of the MSCI EAFE Small Cap Index, through June 2019, the DFA International Small Company Portfolio (DFISX), with a current expense ratio of 0.53%, returned 8.7%, outperforming the MSCI index by 0.9 percentage point. Looking at emerging markets, we find that from its inception in April 1998 through June 2019, the DFA Emerging Markets Small Cap Portfolio (DEMSX), with a current expense ratio of 0.70%, returned 10.5%, outperforming the MSCI Emerging Markets Small Cap Index, which returned 6.4%, by a wide margin.

The body of evidence demonstrates that, in answer to our question, implementation costs do not subsume the size premium – it can be captured with long-only funds. Note that the degree to which funds can capture the factor premium (be it positive or negative) will be determined by the fund construction rules (how much exposure the fund has to the factor) as well as implementation strategy (the degree to which the fund uses patient trading strategies).

We now turn to examining the evidence on value funds. To determine if live funds are able to capture the returns of the value factor, we will compare the returns of Dimensional’s value funds with the returns of appropriate value indices.

From inception in March 1993 through June 2019, the DFA U.S. Large Cap Value Portfolio (DFLVX), with a current expense ratio of 0.27%, returned 9.9%. It outperformed the MSCI U.S. Prime Market Value Index, which returned 9.6%, and the Russell 1000 Value Index, which returned 9.7%. We can also examine the performance of the Vanguard Value Index Fund (VIVAX), with a current expense ratio of 0.17%. From June 1994 through June 2019, the fund returned 9.2%, underperforming the MSCI U.S. Prime Market Index by 0.5 percentage point, and the Russell 1000 Index by 0.4 percentage point. And finally, we can review the performance of the Vanguard Value ETF (VTV), with an expense ratio of 0.04%. From February 2004 through June 2019, the fund returned 8.3%, outperforming the MSCI Index by 0.4 percentage point and the Russell Index by 0.5 percentage point.

From inception in April 1993 through June 2019, the DFA U.S. Small Cap Value Portfolio (DFSVX), with a current expense ratio of 0.52%, returned 11.0%. It outperformed the MSCI U.S. Small Cap Value Index, which returned 10.5%, and the Russell 2000 Value Index, which returned 9.8%. Vanguard’s Small Cap Value Index Fund (VISVX), with a current expense ratio of 0.19% (the Admiral Shares version VSIAX has an expense ratio of 0.07%), returned 8.5% from inception in June 1998 through June 2019, underperforming the MSCI index by just 0.1 percentage point while outperforming the Russell index by 0.6 percentage point. Finally, we can review the performance of the Vanguard Small-Cap Value ETF (VBR). From October 2010 through June 2019, VBR returned 12.2%, outperforming the MSCI index by 1.4 percentage points and the Russell index by 2 percentage points.

From June 1994 (the start date of the MSCI EAFE Value Index) through June 2019, the DFA International Value III Portfolio (DFVIX), with a current expense ratio of 0.24%, returned 5.9%, outperforming the MSCI EAFE Value Index, which returned 5.2%.

From inception in January 1995 through June 2019, the DFA International Small Cap Value Portfolio I (DISVX), with a current expense ratio of 0.68%, returned 7.8%, outperforming the 7.4% return of the MSCI EAFE Small Cap Value Index.

From inception in May 1998 through June 2019, the DFA Emerging Markets Value Portfolio (DFEVX), with a current expense ratio of 0.54%, returned 10.0%, outperforming the MSCI Emerging Markets Value Index, which returned 7.3%.

Conclusion

Well-designed, factor-based funds are able to capture the returns provided by both the size and the value factors. The further good news is that increased competition, in the form of mutual funds and tax efficient ETFs, has led to lower expense ratios, allowing investors to capture more of the available return.

Full disclosure: My firm, Buckingham Strategic Wealth, recommends Bridgeway and Dimensional funds in constructing client portfolios.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.

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