Innovations in portfolio theory don’t come around that often, and fewer still are the worthy research breakthroughs making their way into real portfolios.
In the early 1960’s, William Sharpe introduced the idea that a stock’s sensitivity, or Beta, to the overall market explained its performance. Sharpe would later share the Nobel Prize in economics for this important contribution to financial portfolio theory.
In 1981, Rolf Banz documented a small stock effect. In evaluating all stocks traded on the NYSE, Banz found the smallest stocks outperformed the largest stocks. Building on Sharpe’s work, Banz suggested that not only Beta, but a company’s size mattered, too.
In the early 1990’s, Eugene Fama and Ken French found that a more robust three-factor model did an even better job explaining the returns of stocks. Their model stated the expected return of a broadly diversified stock portfolio—in excess of the risk-free rate—is a function of a portfolio’s sensitivity to three factors:
• the market factor, as measured by the excess return of all stocks relative to the risk-free rate
• a size factor, as measured by the excess return of small stocks relative to large stocks
• a relative price factor, as measured by the excess return of value stocks relative to growth stocks
The underlying premise of the Fama-French model is that small cap and value stocks are riskier than large cap and growth stocks, and therefore should deliver higher returns. This will ring familiar to our clients, who know Vista’s investment approach has always favored small and value stock exposure.
In 2012, Professor Robert Novy-Marx published a landmark paper in which he showed that after adjusting for company size and price, companies with higher profitability delivered better returns.
While more profitable companies would ordinarily be expected to have higher relative prices today and, thus, lower expected returns, Novy-Marx found that not all do. Relative to companies of similar price and size, more profitable companies have been found to deliver systematically higher returns than the market, making their stocks a relative bargain.
Source: “Applying Direct Profitability to Value Stocks,” DFA Quarterly Institutional Review, 2Q 2013, Part Two. US Small Cap Value Indices, with and without profitability, 1979-2012. International Small Value Index and Emerging Markets Small Index, with and without profitability, 1999-2012. Risk measure is annualized standard deviation of returns.
Novy-Marx visited our offices recently and explained that while also having higher expected returns, these more highly-profitable stocks tend to do well when traditional value stocks don’t, and vice versa. Their fortunes are not tied together, so they are a good complement to value stocks.
As the graphic above shows, adding profitability to existing small cap and value strategies around the world would have improved performance, while lowering overall volatility.
The academic community has embraced Novy-Marx’s research, and Dimensional Fund Advisors (DFA) has begun incorporating his findings into their mutual funds. This means the DFA funds used in our portfolios will now favor stocks of small company, low-priced (value) and highly-profitable companies.
Being so close to the leading edge of academic research is just one of the benefits of our association with DFA. We’re excited to share this positive step in the evolution of building better portfolios for our clients.