What Explains the Difference in Market Returns:
Part 1 - Size Matters

In the next few columns, we are going to discuss some sophisticated approaches to refining your investment portfolio. Rigorous academic research has identified stocks with certain characteristics which have historically compensated investors more than others and you can ‘tilt’ your portfolio to take advantage of these findings.

To recap, markets reward investors for taking risks by supplying investment capital to companies. However, not all risks provide expected rewards. It is very difficult for any manager to consistently outperform the market by identifying undervalued stocks, because, over time, markets are efficient in gathering information about securities and then setting prices accordingly. Several of our columns have discussed two approaches to investing that empirically have not worked over time:

  1. Trying to time the market: getting in and out depending on how you perceive the market is responding to various factors
  2. Stock picking: trying to pick individual stocks that will outperform the market

For these reasons, a market-based approach to investing — i.e., buying a market segment — is supported by the analysis of extensive data. However, because there are variations in portfolio returns, the explanation of these variations has been the subject of a great deal of academic research.

Financial science has established that over 90% of the variation in returns amongst investment portfolios can be explained by sensitivity to the following three sources of risk:

  1. Market risk:  A reference to the exposure your portfolio has to the overall stock market.  Greater exposure to stocks versus bonds generates higher expected returns with higher risk.
  2. Size risk, which is discussed below
  3. Value risk, which we will cover in next month’s column

When leading economists Eugene Fama and Ken French researched the historical data on security performance they concluded that company size was a statistically significant factor in explaining expected performance.

 Here's another representation of these results over time:


How small is small? Well, the Russell 2000 index — which comprises the next 2,000 US companies after the largest 1,000 — is commonly used in these comparisons, but there are sophisticated analyses, further breaking down the size effect within the universe of other small companies. Simply put, the smaller the segment the higher the expected return and the higher the risk.

There are several reasons for this. Smaller companies have a higher cost of capital, their borrowing costs are higher.  That higher cost of capital demands higher returns on equity.  Less trading means that small stocks are less liquid than big stocks – meaning more risk. In general terms – a small company has much more upside than a bigger company and much more risk.

Naturally, because investing in smaller companies carries more risk, you must consider how much of your portfolio will be exposed to small stocks. We believe that opportunity exists by tilting your portfolio in a highly diversified fashion towards small companies on a global basis.  This strategy offers exposure to another dimension of risk and higher expected returns. We emphasize that this is a sophisticated investment approach and advise you to work with your investment professional with experience in this area.

This article by Daryn Form was published in the November 2013 issue of SaskBusiness.

What Explains the Difference in Market Returns:
Part 2—The Value Premium

Last month we began a discussion of some sophisticated approaches to refining your investment portfolio, taking advantage of scientific research which explains how risk and return are related. The markets reward investors for taking risk when they supply capital to companies, but not all risks are compensated. Research points to three sources of risk which explain 97% of the difference in portfolio performance: 1) the “market premium” (beta), which is the amount of exposure your portfolio has to the overall stock market, 2) the “size premium” (illustrated last month), and the subject of this column, 3) the “value premium.” 

Once again, the starting point is the Efficient Market Hypothesis: market prices are fair, fully reflecting all available information. Because the markets are efficient, investors who seek higher than expected returns must take on more risk. At any given time, some prices may be too high or too low, but long-term research has established that those who attempt to determine which stocks are under- or over-valued do not succeed over time better than expected by chance. That said, scientific scrutiny of long-term market performance has identified characteristics of certain groups of stocks which have historically outperformed in relation to others. ‘Tilting’ a portfolio slightly to give some exposure to these stocks may allow investors to increase the expected returns of their portfolios.

Last month we saw that stocks of small companies tend to have higher average returns than large companies; the same is true of “value” as opposed to “growth” stocks. Value stocks have a high book-to-market (BtM) ratio compared to those with a low BtM (or “growth” stocks). Book-to-market is the ratio of a company’s value as determined by its accountants to the value of the stock as determined by buyers and sellers of the stock on the market. Eminent economists in this field, Eugene Fama and Kenneth French, defined the value premium as the difference in returns between the stocks with the 30% highest book-to-market ratios and the 30% lowest BtM.

Companies classed as value stocks have fundamentals that look good relative to market value, but less attractive when they are compared to book value. They tend to be distressed in some way and, as a result, have higher costs of capital. For this reason they need to compensate their investors more. The chart below illustrates both the value and the size premiums over the period 1927 – 2012.

It is important to note that these are long-term strategies. Size and value premiums are not necessarily in the positive range in any given time frame (for example, they were negative during the period 1995 to 2000, when the market premium was large), but they are persistent over longer periods of time. Of the two, the value premium has proven more persistent than size.

Note also that maintaining a tilted portfolio can be expensive. Traditional tilted portfolios combine an S&P 500 or other large cap index fund with an assortment of asset class funds. Adherence to investment guidelines may make frequent trading necessary, and small cap stocks are relatively expensive to trade. There are affordable options with reduced trading costs, however, so consult with an investment professional with experience in this field.

These articles were first published in the February 2014 issue of Sask Business, authored by Daryn Form.

Daryn Form is a Senior Financial Advisor with Assante Capital Management Ltd. providing wealth management services to principals of family-owned and privately held companies. Assante Capital Management Ltd. is a member of the Canadian Investor Protection Fund and is registered with the Investment Industry Regulatory Organization of Canada.  The information mentioned in this article is for general information only. Please contact him to discuss your particular circumstances prior to acting on the information above.  The opinions expressed are those of the author and not necessarily those of Assante Capital Management Ltd.  Rates are not guaranteed and are subject to change at any time without notice.