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Engineering for Better Returns

By: Investor Solutions

By: Investor Solutions, Inc.

If you had the ability to surpass market returns over extended periods of time, wouldn’t you do it? Put away the darts, ignore the egocentric cocktail party chatter, and forget your hunches. Achieving above global market returns has nothing to do with luck, skill or paying some “guru” Wall Street analyst. It has everything to do with portfolio engineering!

Successful portfolios are based on research and reasonable expectations, not intuition. Illogical investors attempt to guess which manager, stock or asset class will have tomorrow’s best performance. That’s why so many have consistently failed. Successful, rational investors excel because of a clear methodology and, of course, discipline. What type of investor are you? What type of investor do you want to be?

Risk and reward are related. An investor must be induced with investment return in order to give up a risk free alternative like the Treasury Bill. The same holds true for small company stock. Wouldn’t you demand a greater return to buy a fledgling, unknown company instead of Microsoft? It’s a no-brainer. There’s more risk involved in the transaction, so you should demand to get paid more, right?

Investing in the equity markets can be a risky proposition. For decades, investors believed that relative volatility (Beta) explained most of a portfolio’s return. In truth, market volatility along with two other key risk factors better explains performance.

A pioneering study by renowned academics, Eugene Fama and Ken French, suggests that three risk factors: market, size and price dimensions explain 96% of historical equity performance. This model explains the fact that two particular types of stocks outperform markets on a regular basis: value and small-caps. This pattern persists in multiple time frames and every global market where we can assemble data.

SUMMARY STATISTICS PERCENTAGES
Jan 1960 – Dec 2003
S&P 500 Large Value Small Value
Annualized Return 10.50 13.34 15.90
Total Return 7976 24649 65877
Growth of $1 80.76 247.49 659.77
Annual Standard Deviation 16.76 17.71 25.28
Annual Average Return 11.80 14.75 18.66
*Data provided by Dimensional Fund Advisors, Inc.

The Fama-French Three Factor Model allows investors to calculate the way portfolios take different types of risk and calculate their expected returns. The following exhibit shows how portfolios are plotted using their risk exposures. The vertical and horizontal axes represent the exposures to value and to small. Portfolios exposed to size risk plot along the vertical (size) axis; and those that take risk on distressed companies (growth vs. value) plot on the horizontal (value) axis. Since all equity portfolios assume a market risk, no additional axis is needed. Market risk is represented just below the intersection of the axes, and anything above the line is excess return above market.

While portfolios with exposure to small and value may have different risks than the market as a whole, they are not necessarily higher.

 

Asset classes have unique cycles. When growth is doing well, value may not do as well and vice versa. In some years, small and value may outperform; in others they may under perform. It takes resilience and psychological preparedness to endure the times it under-performs. Remember, investing in small and value should augment the bottom line in the long run, but investors should understand that their portfolio will not identically track the market every single year (and that’s okay).

Deciding on the degree that your portfolio should participate in the three risk factors is the challenge for the investor. Tilting toward small and value will help you reach above global market returns, but portfolio risk must be tempered by adding other assets with low correlations (for example: Bonds, International, International Small, and International Small Value).

So, what have you learned? A little strategic planning goes a long way. Remember, designing a portfolio that favors small and value companies over pure market risk should deliver higher expected returns over extended periods of time. These benefits can be reliably captured by passive strategies (like index funds) that do not rely on either individual stock selection or market timing.

Investors can engineer portfolios that deliver above global market index returns by designing a strategic portfolio tilt. These returns plot comfortably above the market line, shouldn’t you be there too?