As large company growth stocks surged in the late nineties, institutional investors in the US, UK and elsewhere became increasingly disenchanted with traditional active investment managers. This was especially so with those espousing a value style of investing, because they were generally underweighted in these stocks and so underperformed the major stockmarket indices. Institutions reacted by switching large portions of their equity portfolios to index-tracking strategies.
Since the turn of the millennium, however, many of these large company growth stocks have revealed serious weaknesses, as excess capacity has eroded margins and profits. Their stock prices have underperformed and, in their turn, index-trackers have underperformed active managers.
Institutions have not generally responded by reverting to traditional active investment strategies. Rather, they have retained their index commitments but become increasingly attracted to hedge funds and private equity for a part of the ‘active’ component of their equity portfolios.
Clearly there is a belief that there are higher returns to be earned, at acceptable levels of risk, than those available on plain-vanilla index funds. What is surprising is the degree of polarisation of interest, and the relative lack of enthusiasm for products in the middle ground. It is as if institutions believe that the only way to earn higher returns is either to find an investor with a Midas touch, or to shift to a higher-risk, higher-return asset class.
But both theory and experience would suggest that there is, in fact, a whole spectrum of credible equity investment strategies to choose from – from low-risk / low-return to high-risk / high-return.
It is certainly broadly accepted that there is gradation of both risk and return across different asset classes. Thus long-term bonds on average offer higher returns than short-term bills because there is more maturity or duration risk inherent in longer-term investments; corporate bonds on average offer higher returns than government bonds because they carry greater credit risk; equities on average offer higher returns than corporate bonds because they offer less security; and private equity on average offers higher returns than publicly quoted equity because it is less liquid.
It has also long been accepted, at least in academic circles, that this trade-off between risk and return applies within the quoted equity markets – that equities are not just one homogenous asset class but that the shares of higher-risk companies are priced to compensate for that risk by offering a higher expected rate of return.
Professor Sharpe’s original capital asset pricing model suggested that the relative riskiness of individual equities could be described by using a single variable – beta. The more recent work of Professors Eugene Fama and Kenneth French suggests that there are in fact two important dimensions to the risk structure of equity markets (in addition to the risk of the asset class as a whole) – size and “value”; that small companies are perceived as more risky than large companies by investors and than ‘value’ stocks, because they have less clear prospects than growth stocks, are also perceived to be more risky; and that both small companies and value stocks are priced to compensate for this risk and to offer a higher expected return.
Certainly, over longer periods of time, small and value stocks have produced significantly higher actual returns. For example, over the period 1964 – 2001, value stocks in the US equity market returned 14% pa compared to growth stocks’ 10.3% pa, while small companies returned 13.4% pa compared to large companies’ 11.2% pa; similarly, over the period 1957 – 2001, value stocks in the UK equity market returned 18.3% p.a. compared to growth stocks’ 11.4% pa and small companies returned 16.7% pa compared to large companies’ 13.9% pa (‘value’ is defined as the 30% of stocks with the lowest price-to-book ratios; ‘growth’ as the 30% with the highest. In each case the period used is the longest period for which relevant value and growth stock data are available).
This makes intuitive sense: a large established company with good growth prospects would expect to borrow money at a lower rate than a small company with poorer prospects; it would also expect to raise equity capital at a better price (and therefore at a lower expected return to investors). It is entirely logical to expect secondary equity markets to price stocks in a similar fashion; and, as we can see, the evidence suggests that they do.
If this is accepted, then investors can clearly structure their equity portfolios to achieve higher expected returns not just by embracing hedge funds and private equity but also by biasing their mainstream equity portfolios towards smaller companies and value stocks.
There is considerable evidence that many active equity managers are already doing this. A recent study by our firm suggests that more than 90% of the variation of returns on different UK equity unit trust portfolios can be explained by their exposure to large versus small companies and value versus growth stocks, and similar studies in the US explain at least 85% of the variation in this way. In other words, most of what traditional active managers call stock-picking has less to do with individual stock choice, much more to do with choice of type and size of stock. Indeed the average manager’s contribution to returns from individual stock-picking is actually negative.
This implies, as does Fama and French’s analysis, that the benefit of exposure to small companies and value stocks can be captured at least as satisfactorily though a passive, or to describe it more appropriately, systematic investment approach – for example selecting all value stocks above a given value threshold or all small companies below a certain size (subject to prudential exclusions for illiquidity and so forth) – rather than through subjective individual stock selection.
Indeed, such an investment approach would seem to offer attractions relative both to plain-vanilla index-tracking and to traditional active management, as it deliberately seeks to provide the investor with an opportunity to earn higher returns while rendering the inherent risk as transparent as possible.
The market boom and bust of the last five years has shaken investors’ confidence and challenged many embedded beliefs. But there is no reason to believe that the basic principles upon which markets are founded have evaporated. Financial markets price risk and reward it with expected return – not perfectly, but not badly either. It is logical, therefore, for investors to assess their appetite for risk and to organise their portfolios to capture the highest expected return at a level of risk they find acceptable; and a systematic commitment to small companies and value stocks would seem to be a highly credible means of achieving this.
David Salisbury is chief executive of Dimensional Fund Advisors in London
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