The academic research has provided investors with strong evidence there’s a small group of investment factors—or sources of returns—that have delivered higher returns over the long term. To be considered among this small group of factors, the evidence should have the following characteristics:
- Persistence: It holds across long periods of time and various economic regimes.
- Pervasive: It holds across countries, regions, sectors and even asset classes.
- Robustness: It holds for various definitions (for example, a value premium still exists whether we measure value by price-to-book, earnings, cash flow or sales).
- Investability: It holds up not just on paper, but in the real world after considering trading costs.
- Intuitiveness: It includes logical risk-based (economic) or behavioral-based explanations for a premium and why it should continue to exist.
- It should also show that the factor isn’t subsumed by other well-known factors.
While there have been more than 300 factors identified in the literature—so many that John Cochrane called the situation a “factor zoo”—there are only a handful that meet these six criteria.
We gain additional confidence in the existence of a factor when there is out-of-sample evidence. The research team at Dimensional Fund Advisors took a look at the evidence from European equities on the beta, size, value and profitability factors. Their study covered 15 European markets for the 33-year period from 1982 through 2014.
In the interest of full disclosure, my firm, Buckingham, recommends Dimensional funds in constructing client portfolios. That said, the following is a summary of findings from the report, which was just released this month.
The Equity Premium
The average premiums were all positive and, among the countries with returns available from 1982, ranged from 6.5 percent in Italy to 13.4 percent in Sweden. Here we observe evidence of the benefits of diversification. The average equity premium for the European region as a whole was 8.1 percent. This was similar to the 8.5 percent premium in the United States.
The Size Premium
Defining small-cap stocks as the equities that constitute approximately the bottom 10 percent to 12.5 percent of a country’s aggregate market cap ranked on firm size, and excluding equities both with high relative price and low profitability (data availability permitting), the average return premium of small-cap stocks over large-cap stocks in Europe was 2.4 percent.
What’s more, the realized size premium was greater than 2 percent in 10 of the 15 countries the Dimensional research team analyzed. Among larger European markets, the realized premium was sizable in the U.K. (3.6 percent), France (4.8 percent) and Spain (3.7 percent) but weak in Germany (0.1 percent) and Switzerland (0.4 percent). Again, these results show the benefits of diversification. The size premium in the U.S. was the same 2.4 percent.