A Test for Small-Cap and Value Stock Investors

Updated on

A Test for Small-Cap and Value Stock Investors

June 10, 2014

by Robert Huebscher

PDF Print Email Reminder Share

Previous 1 (current) 2 3 Next

Readers of this publication are well versed in the findings of the 1992 Fama-French paper, which documented the outperformance of small-capitalization and value stocks. But few are aware of these two sentences, which appeared in the conclusion of that paper: “Even if our results are consistent with asset-pricing theory, they are not economically satisfying. What is the economic explanation for the roles of size and book-to-market equity in average returns?”

Fama and French’s self-professed uncertainty over why small-cap and value stocks have outperformed the market is particularly interesting in light of Larry Swedroe and Kevin Grogan’s new book, Reducing the Risk of Black Swans: Using the Science of Investing to Capture Returns with Less Volatility, which explains, among other things, the benefits of overweighting those stocks.

Swedroe is director of research for the BAM Alliance, a community of more than 130 independent registered investment advisors. Grogan is director of investment analysis for that firm.

Swedroe and Grogan provide an excellent overview of modern portfolio theory, including the development of the capital asset pricing model, the Fama-French (F-F) paper and newer research, such as the identification of additional factors (e.g., momentum and profitability) that claim to explain elements of risk not explained in the original F-F model.

They demonstrate that the level of market valuation is highly predictive of future returns, based on the Shiller cyclically adjusted price-to-earnings (CAPE) ratio. Swedroe and Grogan then show how to build a “more efficient” portfolio “scientifically” by using funds that overweight small-cap and value stocks. Using historical data, they show that such portfolios provide higher risk-adjusted returns than does a 60/40 stock/bond portfolio. Using small-cap and value stocks, as the authors demonstrate, one needs a lower equity allocation to achieve the same results as a traditional 60/40 portfolio.

The book also discusses Swedroe’s “Larry portfolio,” a term coined by New York Times columnist Ron Lieber in a 2011 article. Exactly how this portfolio is constructed is not clear from the text, but it contains a 28% allocation to U.S. small-value stocks, developed-markets small-value stocks and emerging-market value stocks. The remaining 72% is in five-year Treasury bonds. The Larry portfolio beat a 60/40 portfolio on a risk-adjusted basis using historical data, despite its significantly lower equity allocation.

PDF Print Email Reminder Share

Previous 1 (current) 2 3 Next

Remember, if you have a question or comment, send it to [email protected].

Leave a Comment