Swedroe: Highest Expected Returns Not Always Best

November 13, 2015

A regular reader of my articles contacted me recently to discuss current valuations and a value-oriented strategy. He observed: “It doesn’t matter which approach you like: a value investor doesn’t prefer U.S. stocks now.”

He also pointed out that, while the MSCI World Index currently contains 58.6 percent U. S. stocks, the iShares MSCI World Value Factor UCITS ETF, based on the MSCI World Enhanced Value Index, contains just 38.8 percent U.S. stocks. He then quoted Meb Faber: “A value approach works not just by investing in the cheapest markets, but also by avoiding the most expensive.”

You can see evidence supporting his assertion by looking at the value metrics of value funds managed by Dimensional Fund Advisors (DFA). (Full disclosure: My firm, Buckingham, recommends DFA funds in constructing client portfolios.) The table below compares the price-to-book (P/B) and price-to-earnings (P/E) ratios of the firm’s domestic value funds with those of their international value funds.

Fund Price-to-Book (P/B) Price to Earnings (P/E)
DFA U.S. Large Value III (DFUVX) 1.4 15.0
DFA International Value III (DFVIX) 0.9 12.6
DFA Emerging Markets Value (DFEVX) 0.8 9.0
DFA U.S. Small Value (DFSVX) 1.2 15.7
DFA International Small Value (DISVX) 0.9 12.0

Source: Morningstar, as of Aug. 31, 2015

As the table demonstrates, international and emerging market value stocks have significantly lower prices relative both to book value and earnings than do domestic value stocks. That implies they also have significantly higher expected returns. One measure of expected real returns used by financial economists employs the inverse of the P/E ratio, which gives you an earnings yield.

Thus, the real expected returns for the three large value funds (DFUVX, DFVIX and DFEVX) are 6.7 percent (domestic large value), 7.9 percent (international developed-market large value) and 11.1 percent (emerging market large value), respectively. For the pair of small value funds (DFSVX and DISVX), the expected real returns are 6.4 percent (domestic small value) and 8.5 percent (international developed market small value), respectively.

Returns Not The Only Goal

Clearly, if investors want the higher expected returns, they should consider tilting their portfolios (have a higher allocation) to international developed-market value stocks and emerging markets value stocks. However, earning the highest expected returns isn’t generally an investor’s only objective, or sole consideration.

If earning the highest expected returns possible was, in fact, an investor’s sole consideration, we would likely concentrate portfolios to a greater degree than is prudent. Consider the following. The majority of passively managed value funds, such as index funds, generally categorize a stock as value or growth in one of two ways.

The first common approach is to split the market into halves. The stocks with the lowest prices relative to some metric (such as book value, earnings, cash flow, dividends or sales) are considered value stocks. The stocks with the highest prices relative to that metric become growth stocks.

The second common convention is to split the market three ways. The lowest 30 percent of stocks based on a given metric are classified as value, stocks in the middle are classified as core, and the highest 30 percent are classified as growth. Doing so provides investors with a great deal of diversification, sufficient to minimize the idiosyncratic risk of individual stocks.

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