By: Richard Feldman
By: Richard Feldman, CFP, AIF, MBA
I have analyzed thousands of portfolios over my twelve years in the investment business, most of them individuals or families. The most common element I’ve found across these portfolios is that the largest asset class weighting is typically allocated to large cap US growth stocks. Why? Are investors misinformed? If you look at the raw data value stocks have outperformed growth stocks by a few percentage points since 1979. Value stocks in almost every asset class have markedly outperformed growth stocks since the year 2000 with much less volatility. The question becomes how to structure an optimal portfolio to take advantage of this information.
Value Stocks versus Growth Stocks
How does one determine whether a stock is value or growth? Typically an index will be subdivided into value and growth subsets based on standard value measures such as price/earnings, price/book, or book/market ratios and define the lower priced half as “value stocks” and the higher priced or more expensive stocks as “growth stocks”.
Large Cap Equity Returns
Frank Russell Company offers various indexes that replicate the performance of large cap stocks.
The Russell 1000® Growth Index: offers investors access to the large cap growth segment of the US equity universe. The Russell 1000 Growth Index is constructed to provide comprehensive unbiased barometer of the large cap growth market. Based on ongoing empirical research of investment management behavior, the methodology used to determine growth probability approximates the large cap growth manager’s opportunity set.
The Russell 1000® Value Index: offers investors access to the large cap value market. Based on ongoing empirical research of investment management behavior, the methodology used to determine growth probability approximates the large cap value manager’s opportunity set.
Looking at the long term returns of the Russell 1000 index you will see that large cap value stocks have a much tighter distribution of returns than large cap growth stocks.
The chart above shows the annual returns of the Russell 1000 Value and Growth Indexes from 1979 – 2006. The average annual return for the Russell 1000 Value Index was 15.40% and the average annual return for the Russell 1000 growth index was 13.65%. A portfolio’s volatility is typically measured in terms of standard deviation and as you can see from the chart above the volatility of returns is wider for the Russell 1000 growth index. The chart translates into a standard deviation for the Russell 1000 value of 13.55% and 19.62% for the Russell 1000 growth. Volatility of returns has a direct impact on terminal wealth accumulation. The higher the volatility of returns the less terminal wealth you will build in a portfolio.
Small Cap Equity Returns
Now you might assume that this phenomenon only happens in large cap domestic equities but the data is consistent in both large and small stocks both domestic and international. Let’s take a look at the returns of the Russell 2000 index which is a proxy for small cap equities domestically.
Again you can see from the chart above that the distribution of returns is much tighter for the Russell 2000 value index than the Russell 1000 growth index. The annual average return for the Russell 2000 value and growth index is 17.23% and 12.65% respectively. Again you will notice from the chart above that the distribution of returns for the value stocks of the Russell 2000 is tighter which leads to a standard deviation of 17.26% versus 23.14% for growth stocks.
In developing an optimal portfolio, one would not choose value or growth but choose a combination of both to maximize total return while minimizing volatility in a portfolio. Typically, value and growth stocks shift leadership positions over different market cycles within the U.S. and globally. The numbers show that overweighting value stocks has led to higher portfolio returns with reduced volatility. The data used in this analysis was only twenty seven years because it was based on the Russell 1000 index which dates back to 1979. Longer historical data is available via other indexes and the results are the same. There is a value premium that is consistent domestically, internationally, and in emerging markets as well, in both small and large equities. For some reason individual investors are building their portfolios in the exact opposite manner by overweighting growth stocks. Maybe they like lower returns and higher volatility, but, I doubt it.