- I owe all of you an apology.
This is my 50th video and in all of our time together
there is something that I have never told you.
I have concluded many of my videos with some variation
of you are probably better off
in low cost market cap weighted index funds,
which is a statement that I believe.
What I have not told you
and the reason that I think I owe you an apology,
is that I do not invest my own money
in market cap weighted index funds.
I'm Ben Felix, Portfolio Manager at PWL Capital.
In this episode of Common Sense Investing,
I'm going to remind you that there is more
to sensible investing than market cap weighted index funds.
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Before anyone gets upset, don't worry,
I do invest in a portfolio of index funds,
but they're not all market cap weighted index funds.
Market cap weights means that the weight of each company
in the index fund matches the weight of that company
in the market.
For example, RBC makes up 6.57%
of the S&P TSX Composite Index,
which represents the Canadian market.
So XIC, an ETF tracking the S&P TSX Composite Index
holds 6.67% of its assets in RBC shares.
In a market cap weighted index fund,
you end up with a lot of your money invested
in large cap stocks because they make up most of the market,
and a fairly even mix of value stocks,
which are stocks with lower prices
relative to their book value or earnings and growth stocks,
which are stocks with higher prices relative
to their book value or earnings.
Take a look at this style box analysis for XIC.
You can see that it is mostly large cap
and an even mix between value and growth.
There is nothing wrong with market cap weights,
but there is evidence that certain types of stocks
within the market should be expected to do better over time.
Two of the most prolific examples are small cap
and value stocks.
I know this may sound like active management,
but trust me on this one, you'll want to hear me out.
Let's start with the basics.
Index investing is based on financial markets
being efficient most of the time.
In other words, the market prices of stocks and bonds
are right or as close to right as anyone can get
pretty much all of the time.
In an efficient market, the price of a stock
contains a lot of information.
Expected stock returns are related to risk,
where higher risk generally indicates
higher expected returns.
Risk is reflected in prices and the way
that prices move over time.
There are models called asset pricing models
that help us to understand the relationship between risk
and expected returns.
Asset pricing models have evolved over time
as our understanding of asset pricing has gotten better.
There have been a lot of breakthroughs in asset pricing
and financial market research in the last 60 years.
And a lot of these breakthroughs have been related
to risk factors.
Let me explain.
If we take two portfolios, one 50% equity
and 50% cash and the other 100% equity,
we know that they're going to have
different expected returns due to the different levels
of exposure to the market risk factor, known as market beta.
Differences in exposure to market explains about two thirds
of the difference in returns between diversified portfolios.
If we took two portfolios, one with a 10% return
and one with a 16% return,
their relative exposure to market beta would explain
about 4% of the 6% return difference.
When we talk about breakthroughs and asset pricing,
we're talking about researchers discovering other risks
that consistently explain the differences in returns
between diversified portfolios.
The more independent risk factors that we discover,
the more of the difference in returns
between diversified portfolios we can explain.
There are hundreds of factors that have been documented
in the academic literature,
but only five or so of them are generally accepted
as being true independent risk factors.
The two that we were talking about today
are company size and relative price,
more commonly known as the value factor.
I hope you're still with me.
I have talked about factor investing in the past,
but not like this.
Today, we are going deep.
I mentioned market beta,
any discussion on factor investing
has to start with market beta, it was the original factor.
In the 1960s, the primary asset pricing model
was the Capital Asset Pricing Model or CAPM.
The CAPM looks at the measure of sensitivity
between an asset or portfolio and the risk
of the overall market.
That measure is what is referred to as market beta.
A market cap weighted equity index fund
would have a market beta of one.
A portfolio consisting of 50%
market cap weighted equity index fund
and 50% cash would have a market beta of 0.5.
If the market goes up 10%,
the portfolio with a beta of one would also go up 10%,
while the portfolio with a beta of 0.5 would go up 5%.
It's a measure for the sensitivity to market risk.
In its time, market beta was the only way
that we could compare two portfolios.
If two portfolios had different returns but the same beta,
the unexplained portion of the difference in returns
would be attributed to a manager's ability
to select securities or time to market.
A portfolio manager that can take the same amount
of risk while delivering a higher return
is of course desirable.
That excess risk adjusted return is known as alpha,
which is the holy grail of investing.
The CAPM was the foundation of asset pricing models,
but over time it was shown to be flawed.
As I mentioned earlier, market beta is only able to explain
about two thirds of the differences in returns
between diversified portfolios.
What about the remaining one third?
The CAPM was proven to be flawed
when Rolf Banz wrote his 1981 paper, The Relationship
Between Return and Market Value of Common Stocks.
He showed that small stocks
had consistently had higher average returns
that could not be explained by their market beta.
In other words, viewed through the CAPM lens,
small stocks were generating alpha,
excess risk adjusted returns.
In 1985, the CAPM took another blow
when Barr Rosenberg, Kenneth Reid and Ronald Lanstein
found that stocks with a high book value
relative to their market price,
commonly known as value stocks, had higher average returns
that were again not explained by market beta.
Their paper, Persuasive Evidence of Market Inefficiency
was further evidence that market beta
does not tell the full story
of how the market prices assets.
These findings at the time seemed to be proof
that markets were not efficient.
If some types of stocks
could have consistently higher returns
without any additional risk,
then the market is clearly mispricing those types of stocks.
If that is in fact the case,
then markets are by definition not efficient.
However, Eugene Fama, the man who originally proposed
the concept of market efficiency,
had a very strong rebuttal.
In 1992, Eugene Fama and Kenneth French
pulled together the anomalies
that had apparently been disproving market efficiency
and brought everything back to reality.
They showed that the market was still efficient,
but we needed to account for additional types of risk
independent of the risk of the market
in our asset pricing models.
Instead of the single risk factor model
that had been used for years,
Fama and French proposed a three-factor model
for asset pricing, including market risk,
the risk of small stocks and the risk of value stocks.
When they added in the independent risks of small
and value stocks alongside market beta,
they made the apparent alpha of small cap
and value stocks go away,
and they significantly increased the explanatory power
of the asset pricing model.
Remember that under the CAPM, small cap and value stocks
appeared to have higher average returns
without any extra risk.
The three-factor model showed
that they had higher average returns
because they were exposed to a different kind of risk
that is independent of the market.
Instead of explaining two thirds of the difference
in returns between diversified portfolios,
the three-factor model explains 90% of the difference.
At this point we have three independent risk factors
that explain the majority of differences in stock returns.
Since then, there have been a few more major breakthroughs,
but we are going to stop with the three-factor model today.
So why do we care about these risk factors?
Each of the risk factors, market beta,
size and relative price,
have historically delivered meaningful risk premiums.
Let's take a quick peek at some of that data.
First, we need to understand
how factor risk premiums are measured.
The market risk premium is measured as the return
of the market, like a market cap weighted index
minus the return of one month treasury bills
also known as the risk free asset.
The size risk factor is measured by the return
of small cap stocks minus the return of large cap stocks,
which is why it is referred to in the academic literature
as SMB, Small Minus Big.
The value risk factor is measured by stocks
with a high book value relative to market price
minus the stocks with a low book value
relative to market price,
which is why it is referred to in the literature
as HML, High Minus Low.
All right, so historically in the US,
from July 1926 through December 2018,
the market premium was 6.28% per year on average.
You get that by owning a market cap weighted index fund
like XIC for Canadian stocks, or XUU for US stocks.
SMB, the size premium, was 1.88% per year on average
and HML, the value premium, was 3.78% per year on average.
We're leaving those additional premiums on the table
with a market cap weighted index fund.
When Fama and French came up with their paper in 1992,
they were criticized for data mining,
because they only looked at US stocks.
That criticism was promptly addressed with global data,
which we now have at our fingertips.
We only have data going back to 1990 through 2018,
but globally, excluding the US, the market premium
has been 2.31%, the size premium has been 0.08%
and the value premium has been 4.29% per year on average.
In all cases the premiums are positive,
though clearly in some cases
they are more positive than others.
Global EX US SMB is not that exciting
with a premium of 0.08% per year on average.
I addressed this in detail in my video,
The Problem With Small Cap Stocks,
but in short, small cap growth stocks
with weak profitability makes small caps as a whole
look kind of bad.
If you take them out, which you can do
with the right index fund,
small caps look much, much better.
I want to talk a little bit about persistence.
I have heard some skepticism about the factor's ability
to continue delivering a risk premium into the future.
I would argue that anyone who believes
in the market risk premium has to believe
in the size and value premiums.
They are all based on markets being efficient
and accurately pricing risk into stocks.
If we do not believe in the size and value premiums,
then we should not believe in the market premium either.
If we look at rolling 10 year periods in the US
going back to July 1926 and through 2018,
the market risk premium has been positive 85% of the time.
The size premium has been positive 72% of the time
and the value premium has been positive 84% of the time.
Can we think about that for a minute.
US value stocks have historically been as likely
to beat growth stocks as the market has been
to beat one month treasury bills.
In Canada, value has historically beaten growth
over 10 year periods more often than the market
has beaten treasury bills.
In international stocks, we see the same story,
with the value premium being more reliable
than the market over 10 year periods
and international small stocks have beaten large stocks
with about the same frequency as international market
has beaten treasury bills, 88% of the time for the market
and 87% of the time for small cap stocks.
We are currently living through a period
where small cap and value stocks
have not been that great, even for the past decade.
From the data that we just saw, this is not abnormal.
In fact, it has happened many times throughout history.
But remember, we know from the data that this can happen
to the market, just the same as it can happen
to size and value.
This decade has been great for the market
and not so great for size and value.
Periods like this are expected to happen.
And historically, it has happened to the market
at least as often if not more often
than it has happened to size and value.
The past decade is not a reason
to abandon small cap and value stocks.
I think that these data are pretty compelling.
These factors aren't just some off the cuff observation,
they play a crucial role in our understanding
of financial markets and they have been as reliable,
if not more reliable than the market as a whole
at delivering positive risk premiums over time.
I don't know how anyone can ignore this data.
Now remember, if you own small cap and value stocks
in market cap weights, the weights that exist in the market,
you only have exposure to the risk of the market.
To get exposure to the independent risk
of small cap and value stocks,
you need to own them in weights
higher than they exist in the market.
Practically, this just means loading up
on some additional small cap and value ETFs
on top of your market cap weighted ETFs.
Unfortunately, there are no good ETS
to accomplish this for Canadian and international markets.
There are some good ETS for getting exposure
to US small cap value and value stocks.
Adding these ETFs
to a market cap weighted ETF model portfolio
increases its 20 year historical performance,
improves its worst three year performance
and decreases its standard deviation.
I have written about this in detail
in my recent paper, Factor Investing With ETFs
which is linked in the notes.
Now, I do want to add,
I am not saying that everyone needs to go
and buy small cap value ETFs to be a sensible investor,
just like not everyone needs to go and buy US listed ETFs
in their RRSP to increase their tax efficiency.
For many people, the simplicity of something like VGRO
is the best recipe for success.
I do firmly believe though,
that anyone who is already slicing up their portfolio
for lower costs or increased tax efficiency,
should be considering an allocation
to US small cap value and value stocks
to increase their portfolios diversification,
expected returns and statistical reliability.
In my factor tilted ETF model portfolio
that I propose in my recent paper,
I have used one third XUU or ITOT,
one third IJS and one third IUSV
for the US equity portion of the portfolio
to gain meaningful but cost effective exposure
to the US, size and value premiums.
To be clear, I do not invest
in this ETF model portfolio myself,
I use dimensional fund advisors factor tilted index funds
in my portfolio.
I try to avoid talking about dimensional on this channel
because you can't access their products
unless you're a client of my firm or a firm like it
that dimensional has approved.
My ETF model portfolios are my attempt
at making factor investing accessible to any DIY investor.
Have you thought about adding small cap and value ETFs
to your portfolio?
Tell me about it in the comments.
Thanks for watching.
My name is Ben Felix of PWL Capital,
and this is Common Sense Investing.
If you enjoyed this video,
please share it with someone you think would benefit
from the information.
Don't forget, if you've run out
of Common Sense Investing videos to watch,
you can tune in to weekly episodes
of the Rational Reminder podcast
wherever you get your podcasts.
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