Letters to the Editor

April 22nd, 2014

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The following is in response to Robert Huebscher’s article, A Conversation with DFA’s David Booth, which appeared last week:

I want to pass along some statistics as it relates to simulations DFA ran on their small/value-tilted indexes pre- and post-profitability inclusion (using data starting in 1975). The data are summarized in the table below.

Over the period from 1975-2011 (the last date I have handy on the pre-profitability indexes), adding profitability to the US Large Value index added 1% per year without additional volatility. The U.S. Micro-Cap index added almost 2% per year with more than 1% lower standard deviation, and U.S. Small-Value index saw a 0.9% return bump with about 2% less volatility.

In each case, between 50% and 100% of the higher returns didn’t come from additional exposure to small cap and value (as you can see from comparing annual alphas). At least historically, screening out stocks with negative profitability and holding a few more “relative value” stocks with higher profitability has increased returns while decreasing volatility. The only index of the three that changed materially (based on Fama-French three-factor sensitivities) was U.S. Micro Cap, which doubled its value exposure (a result of screening out high-priced growth stocks with below-average profitability). The size exposure of the U.S. Large-Value index increased a bit, but was more than offset by the decreasing size exposure of the U.S. Small-Value index.

How much of this advantage will persist and can DFA capture in their funds? Time will tell, but I think David Booth has given you the low-end range of the estimate, and these numbers below are closer to the top end.

I also looked at the return differences from 2005-2011, this being approximately “out-of-sample” data after the original studies on profitability began to surface. The (profitability-adjusted version of) U.S. Large Value index did 1.5% better, Micro did 1.1% better, and Small Value did +1.8% better. So this phenomenon doesn’t look like an artifact of data dredging from many decades ago.

Strategy

% Return

Standard Deviation

Annual 3F alpha (thru 12/09)

Pre-Profitability Indexes

US Large Value Index

+13.7%

18.5

-0.96%

US Micro Cap Index

+14.7%

24.1

-0.96%

US Small Value Index

+18.1%

25.8

-0.60%

Post-Profitability Indexes

US Large Value Index

+14.7%

18.6

-0.48%

US Micro Cap Index

+16.6%

22.8

0.12%

US Small Value Index

+19.0%

23.7

0.48%

I also quantified the fund return premia that likely led to your (and my) admiration of DFA in this recent blog article. Morningstar recently reported that 50% of actively managed funds haven’t even survived the last 10 years, and of those surviving less than 20% of the fund categories beat their benchmarks.

Sincerely,

Eric D. Nelson, CFA
Managing Principal
Servo Wealth Management
Oklahoma City, OK

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