Last week, we examined the data (from my new book, “Your Complete Guide to Factor-Based Investing,” which I co-authored with Andrew Berkin) on the odds that the premiums associated with some common investment factors would produce a negative return over various horizons.
We then examined how constructing a diversified factor portfolio might impact those odds of underperformance. Today we’ll tackle factor diversification from another angle, by looking at the annualized returns and annual standard deviation of two simple portfolios.
The ‘Typical’ Portfolio
In the table below, Portfolio A is a “typical” portfolio with an allocation of 60% stocks and 40% bonds. To implement this allocation, it invests 60% in Vanguard’s Total (U.S.) Stock Market Index Fund (VTSMX) and 40% in the Vanguard Intermediate-Term Treasury Index Fund (VFITX). Portfolio B invests its equity portion in small value stocks but keeps its bond allocation in VFITX.
Because the stocks it does hold have a higher expected return, Portfolio B is able to use a smaller equity allocation. In this case, it’s 40% instead of 60%. To implement this allocation, it invests in the DFA U.S. Small Cap Value Fund (DFSVX). (Full disclosure: My firm, Buckingham, recommends DFA funds in constructing client portfolios.)
The reason for choosing DFA’s fund instead of Vanguard’s fund is that it has higher loadings on some other factors. You can see that in the Morningstar data. Their portfolio tool shows that the average market capitalization of DFA’s small value fund is currently less than half that of the Vanguard small value fund (VISVX), and its price-to-earnings, price-to-book value and price-to-cash flow ratios are also much lower. In other words, DFSVX is more “valuey” as well.
The data covers the 24-year period from April 1993 (the inception date of DFSVX) through March 2016. The figures inside the parentheses are the loadings of the funds used on (or their exposure to) each of the factors. To obtain the portfolio’s factor loadings (the figure to the left of the parentheses), we multiply the loading on the factor by the percentage allocation of the fund.