Swedroe: Value Premium Goes Missing

Popularity may have killed the value premium—or did it?

That value stocks (in particular, small value stocks) have provided higher returns for investors over time is both well-documented and well-known. So it’s no great surprise that—as director of research for The BAM Alliance, a community of more than 140 independent RIA firms—I’ve been getting a lot of questions about the recent disappearance of the value premium.

Figure 1 shows the returns of five value funds and five blend funds from the same major asset classes: small U.S. stocks, large U.S. stocks, small developed-markets equities, large developed-market equities and emerging markets. The funds are managed by Dimensional Fund Advisors (DFA) and the data covers the 10-year period from 2005 through 2014. (Full disclosure: My firm, Buckingham, recommends DFA funds in constructing client portfolios.)

Using these funds allows us to view live returns, which include costs, as opposed to looking at index returns.

Figure 1: Blend Vs. Value Funds 

As you can see, in terms of annualized returns, there has been, on average, no realized value premium over the last 10 calendar years. While this certainly has been a disappointment to investors who expected higher returns from value stocks, there was also no harm done to those who “tilted” their portfolios toward value. There was no annualized premium, but there wasn’t any underperformance either.

Small Value Vs. Other Equity Classes

Figure 2 provides annualized returns for various equity classes over the 88-year period from 1927 through 2014. It shows why the lack of a value premium over the last 10 years might surprise many investors and cause them to question their asset allocation decision. Data is based on the Fama-French Indices (ex-utilities).

Figure 2: Returns Of Various Equity Classes, 1927-2014

The outperformance of value stocks, and in particular, small value stocks, relative to other asset classes, has led many investors to consider including more exposure to them than the market has overall. For small value, that share is only about 2 percent of the total market. In addition to the above-market return, the persistent outperformance of small value stocks also has been very high. Consider the following:

• The data set can be broken down into 17 consecutive (nonoverlapping) five-year periods from 1927 through 2011.
• Small value stocks outperformed large growth stocks in 11, or 64 percent, of those periods.
• Small value stocks outperformed the S&P 500 Index in 10, or 59 percent, of those periods.
• Small value stocks outperformed small growth stocks in 10, or 59 percent, of those periods.

While the data shows persistence of outperformance overall, about 40 percent of the five-year periods saw underperformance for small value stocks. Unfortunately, too few investors are willing and able to stay disciplined over such periods, adhering to their plan.

Note also that large value stocks outperformed large growth stocks and the S&P 500 Index in 10, or 59 percent, of the 17 consecutive (nonoverlapping) five-year periods. Observe that whenever large value stocks outperformed large growth stocks, they also outperformed the S&P 500 Index. And the reverse was also true.

Considering A Longer Time Frame

The same set of data provides us with eight nonoverlapping, 10-year periods to evaluate.

• Small value stocks outperformed large growth stocks in seven of the eight periods. The only exception was for the period from 1987 through 1996, when small value underperformed by 0.31 percentage points per year.
• Small value stocks outperformed the S&P 500 Index in all eight periods.
• Small value stocks outperformed small growth stocks in all eight periods.
• Large value stocks outperformed large growth stocks in six of the eight periods, or 75 percent of the time.
• Large value stocks outperformed the S&P 500 Index in six of the eight periods, or 75 percent of the time. Large value underperformed once, and there was one tie (from 1987 through 1996, they both returned 15.29 percent per year).

Even these high rates of persistence demonstrate it’s still possible an investor could wait out a 10-year investment horizon and still face a situation where small value and large value stocks underperform other asset classes.

If there were no chance of that occurring, then there wouldn’t be any risk in allocating to value over growth. As a result, knowledgeable investors shouldn’t be surprised that we have just experienced a 10-year period when value stocks didn’t outperform growth stocks.

My almost 20 years of experience as a financial advisor has taught me that even the most disciplined investors can have their patience sorely tested by as little as even a few years of underperformance, let alone a full 10-year period without higher returns to value stocks. A dramatic example of the potential for underperformance, or what’s referred to as negative tracking error, is the five-year period ending in 1999.

Tracking Error Regret
During that time frame, small value stocks underperformed the S&P 500 Index, which returned 28.6 percent, by 13.8 percentage points. Fama-French small value stocks, ex-utilities, managed to return only 14.8 percent. The longest period during which small value stocks underperformed the S&P 500, at least based on calendar years, was the 19-year period from 1984 through 2002. Small value stocks returned 12.1 percent versus a 12.2 percent return to the S&P 500 Index.

Those who know their investment history certainly shouldn’t be astonished when we have a 10-year period without outperformance. Such periods, however, create risk for investors who fall prey to the dreaded disease known as “tracking error regret.” This malady results in investors regretting their decision to have a portfolio that performs differently than the market. Tracking-error regret causes investors to abandon their well-thought-out, long-term financial plan.

As a footnote, for the 14-year period from 2000 through 2013, Fama-French small value stocks (ex-utilities) returned 12.7 percent, outperforming the S&P 500 Index by 9.1 percentage points per year. That’s called positive tracking error. And I have yet to hear an investor complain about positive tracking error. Of course, the likelihood of periods, even very long ones, with negative tracking error is the price investors must pay to earn above-market returns in the long term.

While value stocks—and small value stocks in particular—have indeed exhibited a high degree of persistent outperformance, there’s certainly no guarantee they will do so in the future, no matter how long the investment horizon. Any asset class can underperform for long periods. If you doubt this, just consider investors in Japanese large-cap stocks, who have experienced returns of -0.8 percent a year for the 25-year period from 1990 through 2014.

The bottom line is that if you’re not prepared to experience very long periods of underperformance, you shouldn’t be investing. That’s true whether we’re talking about stocks or bonds in general, or any individual asset class.

Dining On Diversification

One of my favorite expressions is that diversification is the only “free lunch” in investing. So you might as well eat as much of it as you can. But to enjoy the benefits of diversification, you must be patient.

Warren Buffett once said his favorite time frame for investing is forever. If you are not patient and disciplined, you’re likely to come down with that pesky tracking error disease and abandon your plan. It’s that stop-and-start approach to investing that dooms most investors to poor returns. Though they own stocks, they often end up with bondlike returns.

From 1927 through 2014, the annual average value premium (specifically the HmL premium, or the returns of high book-to-market stocks minus the returns of low book-to-market stocks) was 4.8 percent. However, we also know there’s a tendency for publication of academic research to result in declining premiums. The June 2014 study, “Does Academic Research Destroy Stock Return Predictability,” by R. David McLean and Jeffrey Pontiff found that the average characteristic’s return has a “56% post-publication decay.”

In 1981, Sanjoy Basu’s paper, “The Relationship Between Earnings’ Yield, Market Value and Return for NYSE Common Stocks,” found the positive relationship between the earnings yield and average return is left unexplained by market beta.

Then in 1985, Barr Rosenberg, Kenneth Reid and Ronald Lanstein found a positive relationship between average stock returns and book-to-market ratio in their paper, “Persuasive Evidence of Market Inefficiency.” Together, these two studies provided evidence for the existence of a value premium.

A Diminished Premium

While the HmL premium was 4.8 percent over the 88 years ending in 2014, it was 5.7 percent from 1927 through 1984. For the past 30 years, the annual HmL premium has been 2.9 percent. For the past 20 years, it’s also been 2.9 percent. But in the last 10 years, it’s been just 0.5 percent. Perhaps this trend is a result of more money chasing the value premium.

Advisor Perspectives’ Robert Huebscher took a look at this question and found that, 20 years ago, fewer than 14 percent of mutual funds and ETFs had the word “value” in their name. Today that figure is more than 21 percent. Total assets under management in funds with “value” in their name increased from about 7.5 percent of all assets to about 11.5 percent, more than a 50 percent increase.

Unfortunately, while many pundits claim the ability to foresee what’s in store for the financial markets, all crystal balls are cloudy. There’s no way to know what the value premium will be in the future. A complicating factor is that the academic community is divided about the source of the value premium.

The traditional finance viewpoint is that the premium’s source is extra risk. Value stocks are the stocks of riskier companies. And there are many research papers that provide simple and logical explanations, along with evidence, for why risk is the source of the premium. If the premium is a result of greater risk, while increased flows would be expected to narrow the premium, it shouldn’t disappear.

On other hand, there are also research papers demonstrating that at least some of the source of the premium can be found in the behavioral errors of investors. If that is the case, at least some of the value premium is a result of mispricing. However, even if this is true, limits to arbitrage and the fear and costs associated with shorting can prevent the rational investor from correcting mispricings, allowing anomalies to persist.

Don’t Give Up On Value Yet

While it does appear the value premium may now be smaller than it has been historically, the fact that the most recent 10-year period has seen almost no premium shouldn’t cause you to conclude that the value premium has now disappeared. Ten years is simply far too short a period from which to draw such a conclusion, especially if you believe that risk is the source of the premium.

My own view is that, in giving advice, a financial advisor should act like a doctor, whose first priority is to do no harm. Given the strong body of evidence that at least some of the value premium is a result of risk, there remains no logical reason to conclude that value stocks should have lower returns than growth stocks.

Thus, for investors who are able and willing to bear the extra risks of value stocks, allocating a higher-than-market weighting to value stocks to provide a diversification benefit is a prudent strategy. This is especially true since today there are many well-designed and low-cost funds that do provide exposure to the value factor.

Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.