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.
The Value Premium
The value premium in Europe was 4.9 percent. The premium was positive in each of the 15 individual markets examined in the study, ranging from 1.5 percent in Ireland to 7.3 percent in Sweden. Again, we see the benefits of diversification. The value premium in the U.S. was a similar 4.5 percent.
The Profitability Premium
The average profitability premium in Europe was 3.6 percent. In addition, the realized premium was greater than 2 percent in 11 of the 15 countries studied. It was negative in two, specifically Belgium and Finland. Once again, the benefits of diversification are apparent. The profitability premium in the U.S. was 4.4 percent.
It’s comforting to see that not only did the premiums exist for all four factors in the European markets, but that they were of similar magnitudes when compared with U.S. markets. This type of evidence should give us greater confidence in the reliability of the data.
Risk Is The Reason For Premiums
What’s important for investors to remember is that while each of the expected premiums is positive, everyday realized premiums are impossible to know in advance, regardless of the length of the time frame we consider.
And while financial economists know that even 10-year periods don’t tell us very much, it’s my experience that many investors think that three years is a long time, five years is really long and 10 years is like an eternity. That type of shortsightedness can lead investors to abandon even well-thought-out financial plans.
From a traditional economic viewpoint, the premiums are compensation for risk. Thus, regardless of how long your time horizon may be, it must include the risk that the premiums will be negative. After all, if that wasn’t the case, there wouldn’t be any risk, and thus no premium. This is just as true for size, value and profitability as it is for beta. Consider the following examples:
Over the 40-year period ending in 2008, U.S. large growth stocks returned 8.4 percent and U.S. small growth stocks returned 4.9 percent. Both underperformed 20-year Treasury bonds, which returned 8.9 percent.
We should expect that, just as there are long periods when stocks will provide negative premiums (such as they did from 2000 through 2009, when the S&P 500 lost 1 percent per year), there will be long periods when each of the other premiums will be negative. For example, the value premium was -0.4 percent from 2006 through 2014.
This is not an argument against the existence of these premiums. Instead, it’s an argument for diversifying, not only geographically, but across factors, or sources of returns.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.