As the director of research for Buckingham Strategic Wealth and The BAM Alliance, one of the most asked questions I get about factor-based investing relates to investment horizon.
It goes something like: “The value premium has been negative for the last 10 years, and I don’t have 10 years to wait for a value or size—or any other factor—premium to show up.”
Before addressing this question, note data from Ken French’s website show that, while the value premium in U.S. stocks was down 0.8% per year over the period 2008 through 2017 (and down 8.8% in the first 10 months of 2018), it was actually positive in international stocks—making it hard to claim that the value premium is dead.
The following table, which uses data from Ken French’s website, shows that, no matter which metric was used, there was a value premium in developed international markets from 2008 through 2017.
Note that, using the B/M metric, the developed-market international value premium was down 3.4% in the first 10 months of 2018.
Returning to the question about investment horizon, one of the most important lessons history teaches us is that all factor premiums, including market beta (the return on stocks minus the return on one-month Treasury bills), have experienced long periods of negative returns. My guess is the following data, showing the annualized return to the market beta factor, will come as a big surprise to most investors. Data is from Ken French’s website.
- 14 Years (1929-1943) U.S. Market Beta: down 0.7%
- 15 Years (1969-1983) U.S. Market Beta: down 0.1%
- 13 Years (2000-2012) U.S. Market Beta: down 0.2%
As you can see, we had three long periods where the U.S. market beta premium was negative—investors took all the risks of equities while earning lower returns than they could have earned on riskless one-month Treasury bills.
And that’s without even considering the costs of implementing an equity strategy. Thus, live results would have been even worse. Note also that the three periods make up a total of 42 of the 90 years from 1929 through 2018—that’s 47% of the total period. Equities are risky, and investors require a large premium for taking that risk.
Size & Value
Now, again using Ken French’s data, let’s look at how the size and value premiums performed during those same three periods.
- 14 Years (1929-1943) U.S. Market Beta: down 0.7%; Size: up 5.8%; Value: up 3.2%
- 15 Years (1969-1983) U.S. Market Beta: down 0.1%; Size: up 3.6%; Value: up 6.0%
- 13 Years (2000-2012) U.S. Market Beta: down 0.2%; Size: up 4.4%; Value: up 5.0%
As you can see, in each case, the size and value factors provided large premiums during the long periods when market beta was negative. Of course, that isn’t a guarantee this will always be the case.
However, it does demonstrate the historical and potential benefits of diversifying across unique sources of risk.
Poor Returns Follow High Valuations
It is important to note that all three periods of a negative U.S. beta premium followed on the heels of very strong returns to market beta, well above the historical average. Those strong returns were aided by rising valuations.
For example, the Shiller CAPE 10 rose from 6.0 on January 1, 1920, to 27.1 at the end of 1928. From 1949 through 1968, the Shiller CAPE 10 rose from 10.3 to 21.2. From January 1982 through 1999, the Shiller CAPE 10 rose from 7.4 to 43.8. And now the Shiller CAPE 10 has risen from 15.2 on Jan. 1, 2009, to 29.6 on Dec. 10, 2018.
Note that the current high level of the CAPE 10 doesn’t necessarily mean we’re headed for another long period of a negative beta premium. However, it should at least alert investors to that possibility and, importantly, the likelihood of much lower than historical returns to equities.
Unfortunately, this comes at a time when bond yields are also low, which makes it more difficult for investors to achieve their financial goals. It may require investors saving at a higher rate, planning on working longer or adjusting their goals to reflect a new reality of lower expected returns.
With the historical perspective, we can now answer the question posed about not having 10 years to wait for a factor premium to show up.
Investment Horizon & Factor Premium
The following table, with data from the Fama/French Data Library, covers the period 1927 through 2017. Based on the historical premium, and its volatility, we calculated the odds (expressed in %) of each factor having a negative premium over various future time horizons.
The table shows we should expect even the market beta premium to be negative over 9% of 10-year periods and 3% of 20-year periods. This is likely too optimistic, because today’s higher valuations forecast a lower than historical equity premium, increasing the odds of a negative premium going forward. Given the data, what conclusions should you draw?
The first is that all investing involves the risks of negative premiums, whether investing in total market funds, as recommended by Vanguard founder John Bogle, or investing in factors such as value, size, momentum, profitability, quality and low beta/low volatility.
Market beta is just another factor that can underperform for the most important years in your investment career—the first decade of your retirement. That’s the case because of sequence risk—the order of returns matters greatly in the withdrawal phase, because you cannot recover losses on assets that have been withdrawn to support spending needs.
What’s Your Risk Tolerance?
This understanding leads to the following question: Because any factor, including market beta, can underperform for a very long time, do you want to take the risk that all your eggs might be in the wrong factor basket?
Or is it more prudent to diversify the risks across multiple baskets? The following table is similar to the one we looked at earlier, showing the odds of a negative premium. It adds a portfolio that is equally weighted across the four factors of market beta, size, value and momentum (data is, of course, again from the Fama/French Data Library).
Note that, no matter the horizon, the odds of a negative premium for the equally weighted portfolio are much lower than the odds of a negative premium for market beta. They are also much lower than the odds of a negative premium for any of the factors.
That is due to the four factors having low-to-negative correlations of their premiums. In particular, value and momentum have been strongly negatively correlated.
The bottom line is that, no matter the time horizon, there are benefits of diversification. Those benefits come at the “cost” of accepting the risk that, by diversifying across factors, you are virtually certain to experience some periods, possibly long ones, where your portfolio will underperform a market portfolio.
That’s been the case over the past decade, at least for U.S. investors. However, that was the “luck of the draw.” And only fools judge strategies by outcomes alone, without considering what alternative universes might have shown up.
The future could be very different, as it was from 1929 through 1943, from 1969 through 1982 and from 2000 through 2012. Recognizing that there are no clear crystal balls allowing us to see which factors will outperform in the future, the prudent strategy is to diversify across them, creating more of a risk parity portfolio—one whose risk is not dominated by a single factor.
Unfortunately, most investors are not aware that a “traditional” 60% equity/40% bond portfolio has the vast majority (about 85-90%) of its risk concentrated in one factor—market beta. That’s because they fail to account for the fact that their equity allocation is far riskier than their bond allocation.
For example, a diversified equity portfolio has a volatility of about 20%, about four times the volatility of a five-year Treasury bond portfolio.
For those interested in learning more about how to build portfolios that are diversified by factors, and the benefits that can be gained, I recommend reading the 2018 edition of “Reducing the Risks of Black Swans.”
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.