Scientific progress tends to come in fits and starts. The same can be said for academic finance. A paper is published that shakes the financial world. This is followed by years of confirming and fine-tuning a model until a new paper pushes understanding forward again.
I believe that the past five to ten years have been one of those episodes of breakthrough. Now, with enough time for the academics to confirm those findings, we’re beginning to see new tools that will allow us to use this research to create better, more diversified portfolios.
But to fully understand the new tools, we need to look at the first two major breakthroughs in finance that led us to where we are now.
In 1952, Harry Markowitz revolutionized the financial world when he proved that on average an asset’s (stocks, bonds, etc.) return was based on how risky it was, i.e. risk equals reward. Later, academics showed that you could explain the majority of a portfolio’s return by looking at one factor: its beta.
Beta is a measure of equity-type risk (or market risk) of a stock, mutual fund or portfolio, relative to the risk of the overall stock market. An asset with a beta greater than one has more equity-type risk than the overall stock market, while an asset with a beta less than one has less equity-type risk than the overall stock market.
Basically, Markowitz and others proved that it wasn’t manager skill that generated investment returns but the risk level of the portfolio.
This discovery eventually led to the creation of the S&P 500 index fund. I mean, why pay mutual fund managers huge sums of money if they weren’t adding any value. Just buy the market and save your money.
In addition, Markowitz and others also showed that by mixing certain assets, particularly stocks and bonds, an investor could achieve a higher rate of return for a given level of risk.
Modern Portfolio Theory was born.
Forty years later, Eugene Fama and Kenneth French shook the financial world again. Building on Markowitz’ work, they proved that a portfolio’s return could be better explained by looking at not one risk factor– beta – but also by two other risk factors: 1) size and 2) price. They showed that 90% of a portfolio’s return could be explained by looking at the portfolio’s beta, how much of the portfolio was invested in small stocks versus large company stocks and how much was invested in value stocks versus growth stocks.
(Value stocks are stocks that are relatively cheap, usually because the companies are experiencing difficult times. Growth stocks are companies with growing earnings – but, also, a high stock price.)
French and Fama showed that, historically, small company and value stocks are riskier than large company and growth stocks, which, in turn, led to higher returns.
For the period 1927–2012, the average annual returns to these three risks factors were as follows:
- Market Factor (the return of large, growth stocks minus the return on one-month Treasury bills): 5.85 percent.
- Size Factor (the return of small-cap stocks minus the return of large-cap stocks): 2.30 percent.
- Value Factor (the return of relatively cheap stocks minus the return of growth stocks): 3.98 percent.
In addition, French and Fama showed that the three risk factors were independent of one another, i.e. they pop up at various times. This was an extremely important discovery, because diversification is all about having assets – or, this case, factors – that move up and down at different times.
For example, from 2000 to 2012, beta (the U.S. stock market) didn’t produce any extra return over what you could have earned by investing in three-month CDs. However, small stocks earned you an additional 5% a year while value stocks also earned you an additional 5% a year. The reverse was true for the period between 1982 and 1999, when the small and value premiums were close to zero, while the market premium (beta) was more than 10% a year.
French and Fama’s research was quickly incorporated into the financial industry by the mutual fund company, Dimensional Fund Advisors (DFA). DFA designed mutual funds to capture most of the small and value factors both in the United States and in foreign markets. By mixing these small and value mutual funds with funds that captured beta, investors could increase their returns while lowering their risk level – the Holy Grail of investing.
Over the past decade, new research has uncovered additional factors, such as momentum, liquidity, gross profitability and others. Now, this research is moving into the practical investing world. Some of the factors are being used to enhance the returns of already existing passive mutual funds while others are being used to create mutual funds specifically geared to capture a particular factor, such as momentum or gross profitability.
Much like the introduction of mutual funds that captured the small and value risk factors helped create significantly more diversified portfolios in the 1990s, I believe that these new factors – and the funds that allow us to capture them – will produce even better portfolios.
I also believe that people who view passive investing as simply owning the S&P 500 are missing out on a great deal of diversification. In essence, they own only one risk factor – beta. Certainly, this is better than attempting to time or beat the market through active investing, but they could significantly enhance their returns for a given level of risk if they also diversified their risk factors.
In upcoming articles, I will discuss some of these new factors and how integrating them into your portfolio can improve an investor’s risk-adjusted returns.