Five Factors of Public Capital Market Investing
The Trovena Investment Advisors investment model is based upon the “Five Factors” approach espoused by Dimensional Fund Advisors (“DFA”). Three are stock based and two are fixed income or debt instrument based.
Decades of historical performance and the empirical study of capital markets have led to an undeniable conclusion that returns from investment are directly related to risk. Rewards on invested capital are bound to the amount of capital put at risk, but not all risks are equal or worthy. Rigorous peer reviewed studies, market observations and tested theory have yielded a true science that has revealed which risks are valid and which poorly utilize capital.
Sources: CRSP data provided by the Center for Research in Security Prices, University of Chicago; S&P data are provided by Standard & Poor’s Index Services Group; Fama/French and multifactor data provided by Fama/French; US long-term bonds, bills, and inflation data © Stocks, Bonds, Bills, and Inflation Yearbook™, Ibbotson Associates, Chicago (annually updatedwork by Roger G. Ibbotson and Rex A. Sinquefield).
Some of the attributes of the Five Factor Model are clearly summed up in above graphic. Over the past 80 years, stocks have outperformed debt (fixed income) instruments, small stocks have outperformed large stocks, longer term debt instruments (bonds) are riskier than shorter term debt instruments (bills) and thus offer greater rewards.
Three Stock Factors
- Market: Stocks have higher expected returns than fixed income.
- Size: Small company stocks have higher expected returns than large company stocks.
- Price: Lower-priced “value” stocks have higher expected returns than higher-priced “growth” stocks.
All of the historical studies and observations regarding public capital markets can be reduced to three fundamental factors. Stocks are riskier than bonds and have greater expected returns. Relative performance among stocks is largely driven by the yield advantage of small over large and value over growth. Since smaller value stocks are typically unproven, they are priced at a discount to larger growth stocks which are typically established and have a history of reliable earnings. So the higher risk associated with the small value stocks provides greater potential returns than offered by the larger stocks.
Based upon these three fundamental factors, it is then possible to tailor portfolios of stocks and/or bonds appropriate to various risk profiles. At one extreme is the investor with a high risk tolerance who might have a portfolio of all stocks with a strong bias to small company, value stocks. At the other extreme is an investor with little or no risk tolerance who might have a portfolio with a strong bias to fixed income securities like bonds.
Size and Value Matter
In US dollars. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Developed markets value and growth index data provided by Fama/French (ex utilities). International Value Index data: January 2008 – December 2008: simulated from Bloomberg securities data; January 1975-December 2007: Fama/French International Value Simulated Index provided by Fama/French from MSCI securities data. Simulated strategy of MSCI EAFE countries in the upper 30% book-to-market range. Source: Ken French website. Value-weighted, all four data items not required.
International Small Index data: 1970-June 1981, 50% UK small cap stocks provided by the Hoare Govett Small Companies Index and 50% Japan small cap stocks provided by Nomura Securities; July 1981-present, simulated by Dimensional from StyleReseach securities data; includes securities of MSCI EAFE Index countries, market-capitalization weighted, each country capped at 50%. Emerging markets index data simulated by Fama/French from countries in the IFC Investable Universe; simulations are free-float weighted both within each country and across all countries.The S&P data are provided by Standard & Poor’s Index Services Group. CRSP data provided by the Center for Research in Security Prices, University of Chicago. MSCI data copyright MSCI 2009, all rights reserved.
Two Fixed Income Factors
- Maturity: Longer-term instruments are riskier than shorter-term instruments.
- Default: Instruments of lower credit quality are riskier than instruments of higher credit quality.
We believe that the role of fixed income in a portfolio is not to produce income, but to reduce volatility. The best way to accomplish this is to employ the following strategies:
Use shorter maturities (we prefer maturities under five years).
Use high quality issues.
Use a variable maturity approach.
Use a diversified global approach while hedging all currencies.