Company size, relative price, and profitability are variables that cause differences in average returns
In this column we have often written about diversification as a way of reducing volatility in your portfolio. Research into what drives different higher expected returns has revealed other benefits of broad diversification.
Securities have different expected returns. When researchers examined historical data looking for what causes these differences in average returns, they found the answer in variables like company size, relative price, and profitability. Research has confirmed that these variables offer premiums which persist across time periods and markets. Furthermore, these higher expected returns can be captured in real-world portfolios in a cost-effective manner.
To take an example, the Dimensional US Adjusted Large Cap Equity Index targets the securities of the largest 1,000 companies in the US market, with an emphasis on the small cap, value, and profitability premiums. As shown below, emphasizing these premiums led to an outperformance of 79 basis points annualized relative to the Russell 1000 Index (12.30% vs. 11.51%) from 1979 to 2016. The average return difference of 6 basis points per month was statistically reliable (with a t-stat of 3.42).
The following chart shows the estimated probability of the Dimensional US Adjusted Large Cap Equity Index outperforming the Russell 1000 Index over different investment horizons; it increases from 71% for one year to 96% for 10 years, if we assume their continuously compounded returns are normally distributed with the constant parameters estimated from historical returns. This illustrates the importance of maintaining a long-term perspective: while a positive premium is never guaranteed, the estimated probability of outperformance increases over time.
The estimated probabilities are analytically derived by assuming that continuously compounded returns are normally distributed with constant parameters. The parameters are estimated from the historical returns of Dimensional US Adjusted Large Cap Equity Index and Russell 1000 Index from July 1979 to June 2016. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. http://www.ftserussell.com/
How does diversification impact the probability of outperformance?
To sum up, research shows that it is possible to increase expected returns by structuring portfolios around the small cap, value, and profitability premiums. Because it is not possible to consistently predict which individual stocks are going to do well and contribute to higher realized returns, the most reliable approach is to design a diversified strategy that includes all the stocks that are expected to deliver these returns. A strategy that is not well-diversified may exclude from its holdings the companies that ultimately generate the premiums. A long-term investing horizon is another important factor in realizing these premiums, and further diversification across industries and countries should also be taken into consideration.
Jason Sirman is a Senior Financial Advisor with Assante Capital Management Ltd. providing wealth management services to principals of family-owned and privately held companies. The information mentioned in this article is for general information only. Commissions, trailing commissions, management fees and expenses, may all be associated with mutual fund investments. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Please read the prospectus and consult your Assante Advisor before investing. Assante Capital Management Ltd. is a member of the Canadian Investor Protection Fund and is registered with the Investment Industry Regulatory Organization of Canada.