Swedroe: A Tale Of 3 Small Value Funds

January 31, 2019

Takeaways

There are a few important takeaways. The first is that all three passively managed funds were doing their jobs well. The differences in performance aren’t explained by good or bad management. Instead, they’re explained by the fund’s structure—how they’re designed, and the “laws of style purity.”

When an asset class does well, you should expect the fund with the most exposure to the factors explaining its outperformance to have the highest return. And when an asset class does poorly, you should expect the fund with the most exposure to the factors will underperform.

The second is that choosing a fund should be based on how much exposure you want to the factors, and also a fund’s expense ratio. When making the decision, you want to be sure you weigh both. It might be that the fund with a higher expense ratio is the better choice, as it might have more exposure to the factors that determine returns and carry premiums. In other words, it is not just cost, but cost per unit of expected return (and risk), that matters. The following example demonstrates the importance of understanding this issue.

While VISVX has an expense ratio of 0.19% (their Admiral shares version costs just 0.07%) and DFSVX has an expense ratio of 0.52%, the higher costs of the Dimensional fund have been more than offset by their greater exposure to the size and value factors and their focus on adding value by minimizing the negatives of pure indexing. For the full period that both have existed—June 1998 through December 2018—DFSVX returned 8.6%, outperforming the lower cost VISVX, which returned 7.9%.

In addition, despite its higher expense ratio, from inception in September 2011 through December 2018, BOSVX returned 9.7%, slightly outperforming DFSVX (despite the fact that small value significantly underperformed over the period, with VFINX returning 12.5%). With the underperformance, you should expect that VISVX would have outperformed both DFSVX and BOSVX (which it did), returning 10.9%. The returns data is from Portfolio Visualizer.

Recency Bias

Another important point to cover is the psychological bias known as “recency.” Recency bias causes investors to allow recent returns to dominate decision-making while ignoring long-term evidence.

Over the most recent decade, small value stocks have underperformed the large stocks that make up the S&P 500 Index. That underperformance explains the relative performance of the three small value funds, with VISVX producing the strongest returns.

I’ve learned that one of the greatest problems preventing investors from achieving their financial goals is that, when it comes to judging the performance of an investment strategy, they believe that three years is a long time, five years is a very long time and 10 years is an eternity.

Even supposedly more sophisticated institutional investors—those who employ highly paid consultants—typically hire and fire managers based on the last three years’ performance. On the other hand, financial economists know that, when it comes to investment returns, 10 years can be nothing more than “noise,” a random outcome.

For example, we have had three periods of at least 13 years over which the S&P 500 underperformed riskless one-month Treasury bills:

  • 15 years: 1929-43
  • 14 years: 1963-82
  • 13 years: 2000-12

Financial economists know that all risky assets go through long periods of poor performance, and it requires discipline to stay the course. Such long periods should not cause you to abandon your belief that riskier assets should have higher expected (but not guaranteed) returns.

The three periods of 13 years or longer of negative equity premiums demonstrate that this is just as true of large stocks as it is of small value stocks. The long-term evidence is that small value stocks have outperformed the S&P 500 Index. And that outperformance is intuitive, as small value stocks are much riskier.

For example, since 1927, while the standard deviation of the S&P 500 has been around 19%, it’s been about 28% for small value stocks, according to Fama-French data. Thus, we should not abandon our belief that small value stocks should outperform in the future, nor should we abandon our belief that DFSVX and BOSVX should have higher expected returns than VISVX because they have more exposure to the small and value factors.

Summary

The bottom line is that the returns of the three small value funds we examined are well-explained by their exposure to common factors (market beta, size, value and quality). And while VISVX has the lowest expense ratio, it’s cost per unit of exposure that matters, not just overall cost.

You should also consider the fund’s trading strategy—does it act as price-taker, or does it trade patiently?—as well as its fund construction rules, and its exposure to the common factors that explain returns.

The following table, with data from Portfolio Visualizer, provides the loadings (amount of exposure) for the three funds to various factors. The data covers the period September 2011 (inception of BOSVX) through December 2018.

Note that value exposure is measured by the price-to-book ratio. Also note how BOSVX has the highest exposure to the size and value factors, as well as the quality factor (because of its use of multiple value screens, including not just P/B but also P/CF and P/E and P/S).

 

Factor Loadings (September 2011-December 2018)

 

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

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