A reader asked if I could expand on my post from two weeks back on expected stock returns. Specifically, he asked if I could focus on how tilts toward certain types of stocks could be expected to provide (or subtract) additional expected return beyond what we expect the overall market to do.
In that post, I noted that a reasonable expectation for the long-term real return of U.S. stocks was about 4 percent. However, from academic and practitioner research, we know that certain groups of stocks within the world’s stock markets have historically generated higher returns than the overall market. Tilting toward these types of stocks could lead to a legitimate long-term expectation of outperforming the overall market on a net-of-expenses basis. Before we review some of these strategies, let’s walk through a few caveats.
First, it’s impossible for every investor to tilt toward a specific group of stocks. For example, small-cap stocks have historically outperformed large-cap stocks in the U.S. by about 3.6 percent per year. Small-cap stocks are a small fraction of the overall stock market, though, so not everyone can tilt heavily toward small stocks.
Second, many of the strategies entail slightly higher fund expenses, transactions costs within the mutual fund itself and potentially higher taxes. When thinking about how much additional long-term return you may achieve by using these strategies, you must account for these additional costs.
Third, many of these strategies increase tracking error, meaning the degree by which your portfolio may outperform or underperform the overall stock market. For you to benefit from these strategies, you must be willing to stick with them when they are and are not “working.” In the same way that stocks can underperform bonds for prolonged periods of time, many of these strategies can underperform for long periods of time.
Fourth, some of the strategies can’t be implemented simultaneously. For example, one generally can’t tilt toward both value and momentum at the same time, because the two strategies tend to be highly negatively correlated.
Finally, from an academic point of view, many of these strategies are defined by both long and short positions. If you aren’t willing to short stocks, by definition you can’t capture the full amount of the long-term premium even before accounting for the costs described above.
Tilting Toward Small and Value Stocks
Small stocks have historically outperformed the S&P 500 Index by about 1.7 percent per year over the period of 1927-2012. Large value and small value have outperformed the S&P 500 by 0.1 percent and 3.1 percent, respectively. It’s worth focusing on this last number. What this tells you is that historically if you had owned only a diversified portfolio of small value stocks and paid no expenses or taxes you would have outperformed the market by 3.1 percent per year. After accounting for costs and the degree of tilt toward small and value that most folks are actually comfortable with, the benefits would have been notably less than this number but still meaningfully positive. So, something a bit less than the 3.1 percent number represents a reasonable upper bound on the potential benefits to small and value tilts in the real world.
In an attempt to quantify what the real world looks like, I went back to 1994-2012 and compared the actual returns of DFA Small Cap, DFA Large Value and DFA Small Value to the “academic” series used in the prior paragraph. (1994 is the first full calendar year where all three funds have returns data.) Over that period, you find that the three funds on average underperformed the benchmarks by about 0.60 percent per year. So, after accounting for the historical “on-paper” experience and how these strategies have translated into the real world I think a reasonable assumption is 1-2 percent more long-term expected return for intelligently built size- and value-tilted portfolios (before accounting for taxes of course, which I’ll tackle in a later post).
There are at least two other systematic strategies within the stock market that have generated additional return. Those are momentum and profitability. Stocks that have done well (poorly) in the recent past tend to continue to do well (poorly), and companies that have been highly profitable in the past tend to outperform companies that have been less profitable. Premiums associated with both of these strategies have generally been as large as or larger than the value premium.
However, if you’ve decided to strongly tilt toward value, it’s very difficult to also simultaneously tilt toward momentum and profitability. What a fund manager can potentially do, however, is screen out companies with negative momentum and profitability characteristics and this may improve the return of value-oriented strategies over time relative to ignoring momentum and profitability.
Random Links and Commentary of the Week
The NBA playoffs are in full swing, and I enjoyed this podcast with Bill Simmons and Zach Lowe.