Swedroe: Small Value Lags For 15 Years

February 20, 2019

Using Fama-French research indexes, we see that small value stocks have far outperformed other equity asset classes over the long term. The following are the returns to U.S. equities from July 1926 through September 2018:

  • Small Value: 14.8%
  • Large Value: 12.0%
  • Total Market: 10.2%
  • Large Growth: 9.8%
  • Small Growth: 9.0%

Many investors forget the long-term evidence and, being subject to recency, ask: “What have you done for me lately?” And small value has not been the star performer over the last 15 years that it has over the full 92 years.

Fund Returns

Before considering recent returns, it’s important to note that the above data is based purely on returns to indexes. Thus, they do not include trading costs, which are greater in small stocks. In addition, expense ratios for small value stock funds tend to be higher as well. With that in mind, we can look at Vanguard’s index funds to look at live fund returns; the lowest-cost version available for the full 15-year period is used. We’ll also look at the returns of Dimensional Fund Advisors’ U.S. Small-Cap Value Fund (DFSVX). (Full disclosure: My firm, Buckingham Strategic Wealth, recommends Dimensional funds in constructing client portfolios.) Data is from Portfolio Visualizer and is for the 15-year period ending October 2018.

  • Vanguard Total Stock Market (VTSMX): 8.9%
  • Vanguard U.S. Growth (VWUAX): 9.0%
  • Vanguard Value (VIVAX): 8.2%
  • Vanguard Small-Cap Growth (VISGX): 9.7%
  • Vanguard Small-Cap Value (VISVX): 9.4%
  • Dimensional Small-Cap Value (DFSVX): 8.9%

Note that while small growth outperformed small value, Vanguard’s small value fund did outperform the total market over the 15-year period, though Dimensional’s only managed a tie (due to its higher costs). These outcomes, while not expected, should not be surprising either—at least to those who know their financial history. All risky asset classes go through extended periods of underperformance. If this were not the case, there would be no risk. In fact, using data from Paul Merriman’s website, we see that U.S. small value stocks have been the top-performing equity asset class (including international equities) in 56%, not 100%, of 15-year periods.

Merriman’s data also shows that U.S. small value stocks were the worst-performing equity asset class in just 1% of the 15-year periods versus 19% for U.S. small growth. And U.S. small value had never been the worst performer over a 20-year period (which doesn’t guarantee it won’t be in the future). Note that because small value underperformed small growth in this period, we should expect DFSVX to underperform VISVX, as it has more exposure to the losing asset class (and higher expenses). And that is what we see.

For many investors, 15 years of the virtual disappearance of the small value premium is enough to convince them the small value premium is dead. On the other hand, financial economists know that, given more than 90 years of data on U.S. stocks, 15 years is likely nothing more than “noise”—a random period of underperformance. However, if the small value premium were, in fact, dead, we should see evidence of that in international markets as well.

International Returns

Because Vanguard doesn’t have an international small value fund, we’ll compare the performance of Dimensional’s International Small-Cap Value Fund (DISVX) with that of Vanguard’s Developed Markets Fund (VTMGX). Using data from Portfolio Visualizer, despite its significantly higher expense ratio, over the 15-year period ending October 2018, DISVX returned 8.6% versus the return of 6.0% for VTMGX. DISVX outperformed by 2.6 percentage points despite having the handicap of a 0.61 percentage point higher expense ratio (0.68% compared to just 0.07%)—demonstrating that costs, while important, should not be the only issue you consider when choosing a passively managed fund. Fund construction rules, trading rules and exposure to factors also should be considered. Not all index, or passively managed, funds are created equal.

We can also look to the emerging markets. While Dimensional doesn’t have an Emerging Markets Small Value fund, it does have an Emerging Markets Value Fund (DFEVX, expense ratio 0.57%) and an Emerging Markets Small-Cap Fund (DEMSX, expense ratio 0.73%). Data is again from Portfolio Visualizer. We can compare their returns to that of the Vanguard Emerging Markets Stock Index Fund (VEIEX, expense ratio 0.32%). Over the 15-year period ending October 2018, DFEVX returned 10.0%, DEMSX returned 10.2%, and VEIEX returned 7.8%. Here, too, we see that the higher expenses of the Dimensional funds did not prevent them from outperforming the lower-cost Vanguard fund by 2.2 percentage points and 2.4 percentage points, respectively.

Again, we see that exposure to factors can matter far more than expenses. A variation of an Oscar Wilde quote applies to investing: An investor may know the cost of everything but the value of very little. Cost should be the sole consideration only when you are purchasing a commodity.

The bottom line is, while investors in U.S. small value stocks may have been disappointed by their performance over the past 15 years, given that non-U.S. stocks make up about 50% of global market capitalization, a globally diversified portfolio weighted to small value stocks would still have outperformed a total market approach and would have done so despite their higher implementation costs. And they did—over a period that was one of the worst we have experienced for small value stocks.

Before closing, there’s one other point we need to cover: Has publication killed the premiums in value stocks?

Valuations Matter

I kept a table from a seminar given by Dimensional in 2000. It shows that at the end of 1994, the price-to-book (P/B) ratio of U.S. large growth stocks was 2.1 times higher than the P/B ratio of large value stocks. Using Morningstar data, as of November 26, 2018, the iShares S&P 500 Growth ETF (IVW) had a P/B ratio of 4.9, and the iShares S&P 500 Value ETF (IVE) had a P/B ratio of just 2.0—the spread has actually widened from 2.1 to 2.5. Thus, according to that metric, value stocks are cheaper today, relative to growth stocks, than they were shortly after Fama and French published their famous research. In other words, the ex-ante value premium is now larger, not dead.

We can also look at the price-earnings (P/E) metric. In 1994, according to the Dimensional table, the ratio of the P/E in large growth stocks relative to the P/E in large value stocks was 1.5. As of November 26, 2018, and again using Morningstar data, IVW had a P/E ratio of 19.9 and IVE had a P/E ratio 14.0. Thus, the ratio, at 1.4, was just slightly lower. There’s no evidence here that publication, popularity and cash flows have eliminated the premium.

We see similar results when we look at U.S. small stocks. The Dimensional data shows that at the end of 1994, the P/B of the CRSP 9-10 (microcaps) was 1.5 times larger than the P/B of small value stocks. Using Morningstar data, and Dimensional’s microcap fund (DFSCX) for microcaps and its small value fund (DFSVX) for small value stocks, as of September 30, 2018, the ratio of the funds’ respective P/B metrics was the same 1.5 (1.9÷1.3). When we look at P/E, again the results are similar. At the end of 1994, the ratio of those funds’ respective P/E metrics was 1.2; it has actually widened slightly to 1.3 (17.1÷13.4). Again, I see no evidence that publication, popularity and cash flows have eliminated the premium.

Using data from Ken French’s website, we also see similar results when we look at the period starting in 2008. In 2008, the ratio of the P/B of U.S. growth stocks (4.8) to U.S. value stocks (1.1) was 4.4. By the end of 2017, the ratio had increased to 5.3 (6.3÷1.2), the opposite of what you would expect if cash flows had eliminated the premium.

Summary

Based on the logical, risk-based explanations for the small value premium, as well as the behavioral-based explanations for it, and the lack of evidence pointing to shrinking valuation spreads, the conclusion you should draw is that the most recent 15 years of performance in the U.S. is likely just another of those occasionally occurring, but fairly long, periods in which stocks with historical premiums underperform. As mentioned above, if such periods did not occur, there would be no risk, and no risk premium.

 

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.

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