Rediscovering the Size Effect

Rediscovering the Size Effect

Larry Swedroe, Director of Research, 6/26/2018 The first major anomaly to the first formal asset-pricing model, the capital asset pricing model (CAPM), was the size effect. The size effect is the phenomenon that small-cap stocks on average outperform large-cap stocks over time. The size premium is the average annual return achieved by being long small-cap stocks and short large-cap ones. The size effect was first documented by Rolf Banz in his 1981 paper, “The Relationship Between Return and Market Value of Common Stocks,” which was published in the Journal of Financial Economics. After the 1992 publication of Eugene Fama and Kenneth French’s paper, “The Cross-Section of Expected Stock Returns,” the size effect was incorporated into what became finance’s new workhorse asset-pricing model, the Fama-French three-factor model (adding value and size to the CAPM’s market beta). Unfortunately, the size premium basically disappeared in the U.S. after the publication of Banz’s work. Using data from Dimensional Fund Advisors, from 1982 through 2017, the annual size premium in U.S. stocks was just 0.9% on an annual average basis and 0.0% on an annualized basis. However, it’s interesting to note that, despite the absence of a premium to small-cap stocks, over the same period, Dimensional’s U.S. micro-cap fund (DFCSX) returned 12.2%, providing a 0.6 percentage point higher return than the Vanguard 500 Index Fund (VFINX), which returned 11.6%. I’ll come back to that point in my summary. (Also, in the interest of full disclosure, my firm, Buckingham Strategic Wealth, recommends Dimensional funds in constructing client portfolios.) Size Needs Other Factors The lack of a size premium over the past 34 years has led...
The Long-Term Evidence on Factor-Based Investing

The Long-Term Evidence on Factor-Based Investing

Factor-based investing seeks to capture the long-term premiums highlighted by academic researchers. Factors are the security-related traits/characteristics that give rise to common patterns of return across broad sets of securities. To identify factors, researchers typically construct long/short portfolios that are long the preferred exposure and short the unwanted exposure. Most mutual funds employing factor-based strategies are long only. Funds that are long/short typically are referred to as style premium funds (i.e., AQR’s Style Premia Alternative Fund (QSPRX)). They offer a “pure play” on the premium by eliminating (or by minimizing) exposure to market beta that comes with long-only strategies. Thus, they provide additional diversification benefits. (Full disclosure: My firm, Buckingham Strategic Wealth, recommends AQR funds in constructing client portfolios.) Unfortunately, the financial media and some practitioners refer to factor-based investing as “smart-beta” investing. When asked about the term “smart beta,” Nobel Prize-winner William Sharpe’s response was that it made him sick. While much, if not the vast majority, of what Wall Street will call smart beta makes me sick as well, one can make the mistake of throwing out the proverbial baby with the bathwater. That’s what I believe Bill Sharpe and many others may be doing. I’ve explained before why I think most of what is called smart beta is really nothing more than a marketing gimmick — the result of loading on factors (such as size, value, momentum and profitability/quality) other than market beta. Most smart beta products are not delivering alpha (which is what is often implied by the term “smart”), just beta on other factors. However, as I’ve also pointed out, pure indexing strategies possess certain weaknesses that can...
The Risk and Return Implications of ESG

The Risk and Return Implications of ESG

Larry Swedroe, Director of Research, 6/11/2018 Environmental, social and governance (ESG) investment strategies—along with the narrower category of socially responsible investing (SRI)—have gained quite a bit of traction in portfolio management in recent years. In 2016, funds based on such strategies managed about $9 trillion in assets from an overall investment pool of $40 trillion in the United States, according to data from US SIF. In addition, the organization’s 2016 survey of sustainable investment assets found that in the U.S., climate change was the most significant environmental factor influencing asset allocations. Value Play In ‘Sin’ Stocks? While ESG investing continues to gain in popularity, economic theory suggests that if a large enough proportion of investors chooses to avoid “sin” businesses, the share prices of such companies will be depressed. They will have a higher cost of capital because they will trade at a lower price-to earnings (P/E) ratio. Thus, they would offer higher expected returns (which some investors may view as compensation for the emotional “cost” of exposure to what they consider offensive companies). Academic research has confirmed that the evidence supports the theory. Higher Fees OK Interestingly, Arno Riedl and Paul Smeets, authors of the study “Why Do Investors Hold Socially Responsible Mutual Funds?”, which appears in the December 2017 issue of The Journal of Finance, found that investors are willing to pay significantly higher management fees on SRI funds than on conventional funds, and that a majority of them expect such funds to underperform relative to conventional funds. In other words, investors understand there is a price (in the form of lower expected returns) for expressing their social values,...
The Financial Advisors’ Guide to Being a Better Human

The Financial Advisors’ Guide to Being a Better Human

Tim Maurer, Director of Advisor Development, 3/23/2018 I recently received a text message from my mother that I’ll never forget, letting me know a long-time family friend was checking her mail when a tree branch fell and killed her, instantly. Her legacy is a redemptive one, but her loss no less tragic. In the same week, I heard from a colleague how her sister’s serious medical diagnosis had upended her life and work. And only two weeks prior to that, I was just settling into what I thought was a routine annual meeting with one of my most beloved clients when she floored me with the news that she’d been recently diagnosed with cancer, and would be enduring surgery shortly. This confluence of tragic news stopped me in my tracks. Discontinuing Education So much of the work we do as financial advisors teaches us to educate clients to adequately prepare for and respond to some of the worst news that befalls any of us–like death, disability and divorce. And the longer we spend in our careers, receiving news of painful circumstances that have befallen our clients can become commonplace, even predictable. We’re well trained on the tactical and technical elements of this planning, but we get virtually no training at all regarding how to properly receive this news, how to process it ourselves, and how to help our clients through it. My professional certifications and affiliations require 90 hours of continuing education in a host of technical disciplines every two years, but not a single hour on skillfully, compassionately navigating client grief. We’re inundated with training to become technicians, but suffer...
New Real Estate Scam – Confirm and Verify Again 

New Real Estate Scam – Confirm and Verify Again 

Lately, we’ve seen an increase in fraud schemes related to the sale and purchase of real estate.  Imposters are gaining access to various real estate company email addresses and sending false wire instructions to people. Because the person was anticipating the email they provide the wiring instructions to their advisor and approve the transaction.  Imposters are also gaining access to personal emails. They then use the personal email to send wiring instructions to their financial advisor update wire instructions previously sent to the advisor by the title company. Because the client and advisor were both anticipating the wire, they verbally approve and process the instructions without confirming details with the escrow company. Take action Do not trust closing information or transaction instructions received via email. EVEN IF THEY LOOK LEGITIMATE. To ensure that the transaction is legitimate, you should call or video chat with a trusted person using a verified phone number to confirm the instructions. If you have any questions regarding this information please contact our...
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