Without any question, Jack Bogle has a place on my investing Mount Rushmore. From his teachings, I have learned the importance of having a philosophy, keeping fees low, staying diversified, and above all, maintaining extreme discipline to my strategy.
With that said…
There are some things I do not agree with him on, one of which is the idea that market-cap weighting is the best way to invest. Now for some people, I think it probably is the best way, but the strategy one employs comes down to one question: Can you stick to it?
Before we dive into a bunch of data, I want to give some definitions that will explain the tables I will be using:
- TSM = US Total Stock Market (Represented by VTSMX)
- LG = US Large Cap Growth (Represented by VIGRX)
- SG = US Small Cap Growth (Represented by MSSGX)
- LV = US Large Cap Value (Represented by DFLVX)
- SV = US Small Cap Value (Represented by DFSVX)
- LM = US Large/Mid Cap Momentum (Represented by MSCI Momentum Index until May 2013 (Minus 15bps for Fund Fees). MTUM ETF from May 2013 – December 2016)
I decided to look at different style returns from 1995-2016 (22 Year Period). The above listed funds (MSCI Index for most of the Momentum Data) were used to get a sense of how different styles have compared to a Market-Cap Weighted Index Fund, how they have compared to each other, and if there are any clues that can help us decide on how we might implement investment styles into our investment portfolios.
So, let’s start with the individual style return characteristics over the time period I analyzed:
The US Total Stock Market returned 9.54% over the period we looked at. Right in line with the long-term average actually. Every style, or rather every fund we used to serve as proxies for the styles, outperformed the TSM fund with the exception of Large Cap Growth. To confirm this, I looked at the Fama-French Factor data from Ken French’s site and confirmed that the size, value and momentum factor premiums were all positive over this time frame. Over this time period, these funds performed close to how the famous Fama-French studies predicted they would: SV > LV > LG > SG (“The Black Hole of Investing”).
We should also point out that every style had higher volatility AND a larger maximum draw-down compared to the TSM Fund.
As expected (Well, as I expected), the Value and Momentum categories were adequately rewarded for the increased volatility, which is reflected in their higher Sharpe ratios.
Here is another way to look at the data, broken out by annual returns:
After seeing the first snapshot, we might have guessed that the Value and Momentum strategies would have favorable “Best” to “Worst” year ratios when compared to the Growth strategies. When it comes to behavior though, we can see why the TSM Fund is such a compelling option for most investors:
- Lowest Volatility
- Lowest Max Drawdown
- No “Worst” years
All of those stats are nice, but we just need to invest in Small-Cap Value and call it a day, right? Well, if you told me you were not going to look at your portfolio for 30 years then I would say sure, but there is more to constructing a portfolio than just historical returns.
In fact, the biggest decision when it comes to constructing a portfolio, which we alluded to in the opening, should be centered on our behavioral stance towards volatility and the dreaded tracking error risk. Again, can you stick to it?
When I say tracking error risk, this is what I mean:
Could you imagine earning a total of 4.79% while your friends, co-workers, and mechanic earned somewhere from 53%-83%? Oh, and then NOT making a portfolio change somewhere during that period? Could you imagine how slow and difficult those two years would have been? Exactly. Good luck.
Back to the data. Lets take a look at what the annual tracking error looked like for all 5 styles:
When a cell is highlighted in orange, it means that the annual tracking error for that style was negative in comparison to the TSM Fund for that year. When a cell is highlighted in red, it means that the annual tracking error for that style was over -5% in in comparison to the TSM Fund for that year.
Essentially, the orange cells represent years that most investors would probably become slightly frustrated. The red cells represent years that most investor would become very frustrated. Few investors would bail after one of those years, most would bail after two in a row or two years in three (i.e. Value in the late 90s and Growth in the mid 2000s).
When we take a deeper look, it starts to become clear that investing solely in a Small-Cap Value strategy over this period would have been difficult. Sure the returns were the highest, but the strategies volatility was very high AND the tracking error was extreme in a number of years (It had the highest number of extreme tracking error years; 7). When we boil it down, an investor who stuck with the small-cap value strategy through all of that madness was rewarded for it. The problem is that during the madness, there was no guarantee of the styles success in the future. The Small-Cap Value investor could rely on nothing but faith. And so, the question we have to ask ourselves is:
Could we realistically hold-on to a portfolio that performed like that?
Some will say yes, but most people couldn’t do it.
Now, we don’t have to choose just one style, we can always mix and match them. Based on the following correlation table, it might help:
Note: As a refresher, a correlation of 1 would mean that the two styles move together every month. A correlation of -1 would mean that the two styles move in the opposite direction every month.
Naturally, since everything on this table has its main exposure to the US Stock Market, the correlations will all be somewhat high (Close to 1).
The two that stick out right away are the correlations between LV / SG (0.62) and LM / SV (0.68). Finding correlations below 0.70 for similar asset classes is a great start and may lead us to some ideas on constructing a portfolio. Everything else seems to hover in the 0.70-0.90 range, which we would expect. One other interesting find is the correlation between LG / LM (0.90) as this could be used to swap those styles for each other when testing possible portfolios.
To save you and me a bunch of time, I am going to present the same tables above, but replace single styles with potential portfolio mixes that I came up with.
Lets start with a snapshot of our possible portfolio mixes:
A couple things should stick out right away:
- Every portfolio mix beat the TSM Fund over the 1995-2016 period in terms of return.
- Every portfolio had a higher annual volatility than the TSM Fund over this period as well.
- Every portfolio had a higher Sharpe than the TSM Fund meaning that over this time period, we were rewarded for taking on more “risk” (Volatility).
Note: This is not the first time I have seen this in action. The more I do historical research, the more I continue to believe that market-cap weighting is not the “best” strategy, assuming you can stick to unique strategies.
Here is the same data broken out by annual returns:
As we can see, the “Best” and “Worst” ratios favor three portfolios. In fact, the two portfolios that had Large-Cap Momentum exposure, had the least amount of “worst” years (1 each). Not coincidentally, those two portfolios had the highest Sharpe ratio as well.
Okay one more chart since I use Excel way too much:
Okay, so we just need to invest in the Large-Cap Momentum and Small-Cap Value portfolio and call it a day, right? Well, as we learned above, there is more to sticking to a portfolio than just the historical returns.
Lets see if the annual tracking errors of these portfolios versus the TSM Fund can give us anymore clues:
Real quickly, I want to point out something very important:
Even though everyone of these portfolios beat a TSM Fund over this period, they ALL had at least 8 years of under-performance. That means in any given year, there was a roughly 40% chance that anyone of these portfolios would have lost to the TSM Fund. This is essential to understand. The only way to every beat the index, is to be different than the index. If you cannot be comfortable with that, stop reading this and go buy a market-cap weighted index fund (Sorry I made you read this far before saying this).
Good news, for the portfolios exposed to Momentum, they had the least number of bad tracking error surprises (2 and 1). They also had the lowest average negative tracking errors.
Here is another way to look at the behavioral challenge that straying from the index presents:
Once again though, the momentum portfolios performed well in the behavioral tests.
I have to admit, the Large-Cap Momentum / Small-Cap Value mix is very compelling. Aside from the strong returns, volatility, Sharpe ratio, and low correlations between the two styles, the behavioral risks are quite stomach-able also. As an extra bonus, its a rather simple strategy. All you need is two funds.
It only had two extreme tracking error years that were spread a decade apart. The dangerous late 90s period which saw the “All Value” strategy get crushed, was not too bad for the LM / SV portfolio. Only 1998 was dangerous. Frankly, the most recent decade (2007-2016) may be the most frustrating period so far.
Take a look at the following annual spreads for the LM / SV portfolio versus the TSM Fund based on different time periods:
Now look at the most recent decade:
Of course, this is not that a big of a surprise in hindsight. Almost any strategy that has deviated from a Market-Cap Weighted approach over the last decade has struggled. The question moving forward is:
- Was this just a short period where the strategy has failed to out-perform? Or have investors caught on to these factors, and out-performance moving forward will become increasingly smaller until it is eventually gone?
The answer depends on your conviction in these styles. I personally believe that over the long-term, they will continue to persist. Part of that is because I have done a lot of reading and research on them and so I have a strong belief in them. Someone who has not done the same amount of research may say otherwise.
To those people, I pose a question to prove a point: How should we invest moving forward based on the following table?
Yes, the US Total Bond Market Fund beat the US Total Stock Market Fund over the 17 year period from 2000-2016. Does this mean we should make bonds the core component of our long-term holdings?
I expect very few people would answer yes. This is because they have conviction, based on long-term data, that over long periods, US Stocks will beat US Bonds. I would not argue that and only use this an example to explain my own conviction.
Ideas like Momentum and Value go back hundreds of years and I personally believe that over long periods of time, investors who can stay invested in these strategies when they under-perform over shorter periods, will be rewarded over longer periods. My belief is that behavior trumps ideas in the investing world and if you can hold on, you have a chance.
I will let you know how it works out in 30 years…
Have some fun out there!
Note: I will be doing a similar analysis on these styles for International Stocks in the next week, followed by a third piece that puts the U.S. and International data together.
Note: I decided to go back and look at the full sample period from the Fama French site of 1927-2016 and see what a 100% SV portfolio, a 60% SV / 40% LG portfolio, and a 60% SV / 40% LM portfolio would look like in comparison to a TSM portfolio:
Again, the Small Value portfolio had the highest returns, but the trade-off is that the 100% Small Value portfolio could be very challenging to stick to over long-periods. That needs to be a factor in how you invest!