Comparing Dimensional’s Results
Based on research showing evidence of the small growth anomaly, Dimensional Fund Advisors has long used screens in its funds’ construction rules to eliminate “lottery stocks” (that is, penny stocks, IPOs, stocks in bankruptcy, and small growth stocks with high investment and low profitability). Thus, by reviewing the results of the firm’s small-cap funds, we can determine if there has still been a small-cap premium that investors could have captured, not only in the United States but also in developing and emerging markets.
So that we can use all live funds, the period we will examine covers the almost-20-year period April 1998 through December 2017. We will also examine the last 10 full years of the period (2008 through 2017). (Full disclosure: My firm, Buckingham Strategic Wealth, recommends Dimensional funds in constructing client portfolios.)
Note that in each case, the live small-cap portfolios run by Dimensional Fund Advisors, which include not only expense ratios but all implementation costs, outperformed their large-cap index counterparts (which do not have any expenses) by wide margins. For the longer period, the annualized outperformance was 2.5 percentage points in the U.S., 4.4 percentage points in developed markets and 4.0 percentage points in emerging markets. For the more recent 10-year period, the outperformance was 1.5 percentage points in the U.S., 3.7 percentage points in developed markets and 2.7 percentage points in emerging markets.
Compare these figures with the Fama-French U.S. Small Cap Index’s 1.7 percentage point outperformance of the S&P 500 (11.9% versus 10.2%) since July 1926. In so doing, it certainly doesn’t look like the size premium has disappeared. At the very least, we can say that for almost the last 20 years, intelligently designed, passively managed small-cap funds have been able to capture a size premium.
Before summarizing, we’ll review the findings of an important research paper from AQR Capital Management.
Controlling For Quality
Cliff Asness, Andrea Frazzini, Ronen Israel, Tobias Moskowitz and Lasse Pedersen, authors of the January 2015 paper, “Size Matters, If You Control Your Junk,” examined the problem of the disappearing size premium by controlling for the quality factor.
They note: “Stocks with very poor quality (i.e., ‘junk’) are typically very small, have low average returns, and are typically distressed and illiquid securities. These characteristics drive the strong negative relation between size and quality and the returns of these junk stocks chiefly explain the sporadic performance of the size premium and the challenges that have been hurled at it.”
On the other hand, high-quality stocks have the following characteristics: low earnings volatility, high margins, high asset turnover, low financial and operating leverage, and low idiosyncratic risk.
Research shows these stocks, the kind of stocks Benjamin Graham and Warren Buffett have long advocated buying, outperform low-quality stocks with the opposite characteristics—those “lottery-ticket” stocks.