New Paradigm Or Same Old Hype In Equity Investing? by LSV Asset Management
Louis K.C. Chan, Jason Karceski, and Josef Lakonishok
The recent relative stock-price performance of six U.S. equity asset classes (classified by size and by value-versus-growth style) differs markedly from the historical pattern. Large-capitalization growth stocks have apparently taken the place of small-capitalization and value stocks in investors’ hearts. Have the size and value premiums of the past vanished for good? We explore three explanations of recent market behavior—the “rational-asset-pricing” hypothesis, the “new-paradigm” viewpoint, and the “behavioral” or “institutional” explanation. In our study, we examined the operating performance of the equity classes to see which hypothesis accounts for the recent behavior of returns. Our findings provide the most support for the behavioral explanation.
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New Paradigm Or Same Old Hype In Equity Investing?
A large body of research into U.S. equity returns over many years has found consistent differences among the returns of various equity classes. In particular, small-cap stocks have historically outperformed large-cap stocks and value stocks have had higher returns than growth stocks. Table 1 shows annual returns beginning in 1970 for six equity asset classes – small, medium, and large companies (based on market value of equity) subdivided into growth and value categories. (Our classification procedure is detailed in the “Methodology” section.)
The part of the sample period from1970 to 1990 has been the subject of intense study by academics, and the results are by now familiar: Small-cap stocks did well, and small-cap value stocks did particularly well in this period. In the 1980s, for example, as shown by Panel B, small-cap value stocks produced a geometric mean return of 21.7 percent a year whereas large-cap value stocks produced a mean return of 19.4 percent a year. Value stocks in general earned higher returns than growth stocks in this period. For example, largecap value stocks outperformed their large-cap growth counterparts by 4.5 percentage points (pps) a year. Mid-cap value stocks earned 19.3 percent a year, whereas mid-cap growth stocks earned only 15.7 percent a year. Finally, small-cap value stocks outperformed small-cap growth stocks by 9 pps a year, on average, over the 1980s.
These patterns in historical returns have made a significant impact on research and practice in finance. The cumulative weight of the evidence up to the 1990s was enshrined in a highly influential paper by Fama and French (1992), in which size and book value to market value emerged as the leading explanatory variables for the cross-section of average returns. Investment strategies based on the “size anomaly” and the “value premium” caught investors’ attention.
Yet, even as the size and value effects were gaining academic respectability, as well as investor interest, the tables began to turn. The more recent experience has not been kind to the size effect. For the 15-year period from 1984 through 1998, the annual return on the Russell 1000 Index of largecap stocks was 17.71 percent, compared with 11.22
percent for the Russell 2000 Index of small-cap stocks. In only four years out of 15 did the Russell 2000 beat the Russell 1000. The outperformance of large-cap stocks is even more striking if only the most recent period is considered. Table 1 shows that the average return on large-cap growth stocks over the five years up to 1998 was 28.3 percent,
compared with 11.3 percent for small-cap growth stocks; for the three years up to 1998, the averages were, respectively, 34.0 percent and 10.4 percent.
The returns to value stocks have also faltered recently in comparison with those to growth stocks. For example, large-cap value stocks from 1990 through 1998 (see Panel B) earned a mean return of 17.2 percent, falling short of large-cap growth stocks by 2.9 pps a year on average. Small-cap and mid-cap value stocks, however, kept their advantage against their growth counterparts on average. Overall, value stocks were outpaced by growth stocks (in each case combining large-cap, mid-cap, and small-cap stocks in proportion to their market values) by 1.1 pps a year on average over 1990- 1998. The average underperformance was 1.6 pps for 1994–1998 and 3.3 pps for 1996–1998. Performance in 1998 was notably disastrous for both small-cap and value stocks. In that year, large-cap growth stocks experienced their highest return (41 percent) of the 29 years covered in Table 1. In contrast, small-cap value stocks earned a return of –1.2 percent while mid-cap value stocks were earning a meager 6 percent. The returns on the Russell indexes for the 1986–98 period (see Panel C) tell a similar story. Clearly, the price performance record of small-cap and value stocks has taken a serious beating, at least in the last five years.
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