“Implementing the great ideas in finance for clients” is the stated mantra of Dimensional Fund Advisors’ founder and executive chairman David Booth. But at times of market stress and volatility, such as this year and in March in particular, even the most sophisticated and long-term-focused investors can question the validity of great ideas.
One of the great ideas of investment management has been value investing, the principles of which were first espoused by Benjamin Graham and David Dodd in 1934. And perhaps none has been more severely tested of late than value investing as valuations spreads have widened and growth stocks have outperformed.
March 2020 will probably be remembered alongside October 2009 and October 1987 for its extreme market movements. For value investors, the month was also a particularly severe trial.
High return dispersions coupled with outright poor value and small-cap performance has been an unsettling combination for clients, acknowledges Dimensional’s co-CEO and CIO, Gerard O’Reilly.
“In general, no secret. Value did pretty poorly in the first quarter, and in particular deep-value did very poorly.
“And so if you look at the performance of our strategies that have overweights to value, they generally underperformed their benchmarks, even their value benchmarks. Because when we go value, we generally go pretty deep. So when value does more, we do more, and when value does less, we do less. That’s been a way to think about it.”
Typically, a Dimensional equity strategy will overweight small-cap and profitability, in addition to value. The problem is that dispersions between value and growth stocks, and also small and large-cap stocks, have been considerable.
“If you look at realised premiums, the difference in returns between small-cap stocks and large-cap stocks, or the difference in returns between value stocks and growth stocks, they were very, very large,” O’Reilly points out. “Very negative value premiums, very negative small-cap premiums.”
Dimensional also eschews factor timing, having concluded that the results are no better than what could be expected from a random walk. O’Reilly says: “Yes, you can find different timing mechanisms in the historical data that have had higher returns, but when you put it in the context of all of the experiments that are run, it’s about the number that you would expect by chance alone.”
To emphasise this, O’Reilly points to a week in April 2020 in which the order of magnitude of the size and value premiums in that short period were about or even greater than what would usually be expected in a whole year.
Maintaining constant exposure means “you don’t have to be that precise, because when the premiums show up, they show up real quick. We keep ourselves very much focused on size, value, profitability, premiums, all the time, because we never know when they’re going to show up.”
Academic backing has been part of Dimensional since its inception in 1981 and Eugene Fama and Kenneth French still sit on the main corporate board.
If labels are required, Dimensional prefers to describe itself as a “systematic fundamental” manager.
The CIO explains: “The systematic piece is the process. It’s doing the research, it’s saying, ‘what can you say robustly about these various different premiums, and how does it translate into a portfolio design?’.” In other words, stocks or bonds with similar expected returns share certain characteristics.
“The fundamental is, don’t forget that expected returns are driven by two things, the price that people pay, and the cashflows that you’re going to get from the investment.
“Whatever research you do, don’t forget that fundamental view of the world, don’t disconnect yourself from prices, and don’t disconnect yourself from expected cashflows to investors.”
Translating the same systematic fundamental thinking into fixed income, one example is that bonds of similar credit quality can be expected to have similar returns.
But not all credit ratings are created equal, you might say. Dimensional’s research shows that across markets, about 15% of bonds trade at a lower implied credit quality than the official rating, with a higher downgrade frequency of about 30% versus 10% for other bonds.
So the firm applies what it calls ‘enhanced credit ratings’, where portfolio managers supplement official ratings with market information such as trading or index prices, in addition to pricing from dealer inventory, equities or credit default swaps.
“We think about the prices and what information we can extract from those prices in addition to credit quality. We use that to have what I would say is a more real-time informed view of credit quality that’s informed by all market participants, it’s updated in real time, all the time.”
March 2020 also produced high return dispersions across the fixed-income market, with a spread of US government bonds over credit of about 11%, for instance, of US governments over non-US of 7%, and of US governments over TIPS of 6-7%.
“In isolation, over a course of a quarter, they’re not unusual numbers, but the return differences of that magnitude are very unusual to have all over the same quarter,” O’Reilly points out.
For him, one of the lessons from this downturn for investors is how high return dispersions can be, either within bonds or equities or between the two asset classes. This could help them formulate views appropriate for asset allocation.
As for value versus growth equity performance, what should investors bear in mind? O’Reilly points to the drivers of different expected premiums for size, value, profitability or investment factors – the discount-rate effect, low price, or high expected cashflows.
“You’ve got to keep on doing the research to make sure that you have the right variables to say who has low price, who has high expected cashflows. And what we’ve seen over the past couple of years in particular, is a very bad draw for deep-value stocks relative to growth stocks but nothing that would say, based on the historical data, that this is somehow broken, things are now different, high-price stocks are the ones with high expected returns going forward.”
Value may yet see its day. While its status as one of the great ideas of investing is not in doubt, whether investors keep the faith is another matter.