The Factors Of Returns

The idea of exposing an investment portfolio to various “factors” (i.e. small company stocks, value stocks, etc.) as a means to improve returns has been around for decades. The value premium traces its roots back to the mid-twentieth century with the work of Benjamin Graham. Warren Buffett, a student of Graham, used value investing early on in his career to help build his fortune. Research on the size premium (small company stocks outperforming large company stocks) goes back to early 1980s and the work of Rolf Banz. [1]

All of this was a mere pregame to the work of Eugene Fama and Ken French. Their 1992 paper, The Cross Section of Expected Stock Returns, [2] developed what we now know as the three-factor model. They firmly cemented the small company and value premium phenomenon by attributing portfolio returns to three factors: market risk, size premium (small minus big or SMB) and the value premium (high book-to-market minus low-book-to-market or HML).

If assets are priced rationally, our results suggest that stock risks are multidimensional. One dimension of risk is proxied by size, ME. Another dimension of risk is proxied by BE/ME, the ratio of the book value of common equity to its market value. [2]

Fama French Model Factor Portfolios

In plain English: small companies outperform large companies, and value companies beat growth companies. (Full disclosure–I use small cap and value funds for almost all of my domestic equity and international developed markets equity exposure. I’ve drank the Kool-Aid so-to-speak.)

What’s really fascinating is that these factors have continued to perform despite the democratization of this knowledge. They weren’t arbitraged away as one might expect, and the evidence exists in the returns of real world funds (even after accounting for fees). A simple illustration can be made using Vanguard funds. Their small cap value fund came online in May of 1998, so returns are compared from June 1998 through May 2016.

Vanguard Factor Funds

Returns Of Vanguard Factor Funds
(June 1998 – May 2016)
Symbol Cumulative
Vanguard Total Market Index VTSMX 184.7% 6.0%
Vanguard Value Index VIVAX 168.3% 5.7%
Vanguard Small-Cap Index NAESX 285.1% 7.7%
Vanguard Small-Cap Value Index VISVX 326.7% 8.3%

I could continue to extol the virtues of factor investing, but that’s been done by too many at this point, and my conclusion isn’t anything new, exciting or unexpected. The evidence for owning value and small cap stocks as a means to earn excess returns has been very compelling. Instead, I thought it would be a fun experiment to argue against owning them and expand my perspective.

1. They’re expensive (sometimes)
As with any other investment vehicle, fees and costs matter–A LOT. The more you pay the less you get to keep and the less there is to compound into the future.

Expenses Of Vanguard Factor Funds
(June 2016)
Symbol Expense Ratio Turnover
Vanguard Total Stock Market VTSAX/VTI 0.05% 3.5%
Vanguard Value VVIAX/VTV 0.08% 7.8%
Vanguard Small-Cap VSMAX/VB 0.08% 10.7%
Vanguard Small-Cap Value VSIAX 0.08% 15.5%
Vanguard FTSE Developed Markets VTMGX/VEA 0.09% 3.3%
Vanguard FTSE All World ex-US Small Cap VSS 0.17% 8.6%
Vanguard International Value VTRIX 0.46% 36%

The difference in expense ratios among the domestic funds is less than a handful of basis points. From my perspective that’s not enough to discriminate based on ER alone. Historically speaking, the returns provided have justified this small increase in cost. As it turns out, paying a nickel to earn an extra dollar isn’t a bad strategy.

The differences really start to emerge when international funds are considered. Eight additional basis points for the international small cap isn’t too bad, but 37 additional points for the value fund! Vanguard also doesn’t offer an admiral share class or ETF equivalent, and it’s actively managed. C’mon Vanguard! (The iShares EAFE Value fund, EFV, is a nice alternative at 0.40%, but still a little on the pricey side.)

There’s an additional wrinkle to fund expenses that gets reported but is often overlooked as an expense. Turnover measures how frequently assets are bought or sold within a fund or portfolio. Higher turnover ratios mean more buying and selling has taken place within the fund. As a consequence more assets end up being used to pay additional expenses such as commissions and bid-ask spreads. Just because you, the fund shareholder, don’t see these expenses directly doesn’t mean they aren’t being charged. Someone (you) is paying for the fund to transact on various exchanges by way of reduced rates of return.

The problem with value and small cap funds is that their constituents are much more transient. These companies either grow to become large companies or growth companies, or go out of business. Either way there’s a lot more churn going on in these indexes compared to a total market fund.

Turnover creates another problem when mutual funds are used within a taxable account. Selling assets that have appreciated in price results in a capital gain distribution that will be taxed. Thus higher amounts of turnover imply higher amounts of taxable capital gains. However, the authorized participant structure of ETFs has pretty much eliminated capital gains distributions to ETF investors. Stick with ETFs in taxable accounts and taxes will only have to be paid when shares of the ETF are sold (at a profit). [3]

2. They’re risky
There’s this concept of a risk premium that states high risk assets carry with them the expectation of higher future returns. Since the excess returns have clearly been real, it follows that these assets must carry some additional amount of risk.

Traditional “Risk” Measurements Of Vanguard Factor Funds
(June 1998 – May 2016)
Volatility Drawdown
Vanguard Total Market Index 16.0% 56.5%
Vanguard Value Index 15.8% 61.3%
Vanguard Small-Cap Index 20.2% 61.1%
Vanguard Small-Cap Value Index 19.1% 64.1%

There’s a clear trend to higher amounts of “risk” when the traditional metrics are considered–both standard deviation and maximum drawdown were higher for small cap and small cap value funds. But let’s not miss the forest for the trees. The maximum drawdown for all of these funds was pretty substantial. A few extra percentage points here or there is peanuts. The bigger problem is likely to be hanging on when such a drawdown occurs.

Numbers aside, there’s a more qualitative aspect of risk, that is you’re holding a basket of troubled companies that have been devalued for a reason. I like the following description from William Bernstein

Fama and French finally settled on the “sick company” theory of risk. Value companies are “sick” and because they are less likely to survive, must offer higher returns to offset this risk. (Some spoke in hushed tones of a massive financial intensive care unit, presumably somewhere in lower Manhattan, containing vast numbers of companies maintained on the fiscal equivalent of ventilators and potent antibiotic and heart medicines.) [4]

Let’s not confuse owning a value index fund with the work of the great value investors (Klarman, Marks, Greenblatt, Buffett, et al). Those individuals are and were buying into real distressed companies and took on real risk for which they were compensated by way of higher returns. Holding an index fund of value stocks greatly reduces the risk from any individual company through diversification. Don’t expect to be earning Klarman-like returns when buying VBR.

Most mutual fund shareholders (and particularly index fund shareholders) could care less if several percent of the companies their fund owns wind up on the wrong side of the daisies each year as long as the whole portfolio does well. The key point being that the risk of owning sick value companies is for the most part nonsystematic—it is easily eliminated by owning a diversified portfolio of sick companies. And, as any efficient market student knows, you are not rewarded for bearing nonsystematic risk. (Or, in the words of Paul Samuelson, you are not rewarded merely for going to Las Vegas.) [4]

3. They require patience
Probably the most important point to consider when investing with small cap and value funds is that the return premium has been very inconsistent. It hasn’t shown up every day, month, or year. This fact was readily apparent in the annual Fama-French factors for small company and value stocks.



The mid 1940s through the early 1960s were a desert for a diversified portfolio of small company stocks. On the value front Buffett took a great deal of criticism during the late 1990s when large growth internet companies were booming. What these instances demonstrate is that actually earning a premium with these two factors likely requires a great deal of patience. Famed value investor Joel Greenblatt said as much in an interview with Morningstar

Well, actually the secret to value investing is patience, and that’s generally in short supply now. The reason it doesn’t get arbitraged away is that in typical arbitrage, the usual explanation is that you buy gold in New York and simultaneously sell it in London for $1 more. And what tends to happen in typical arbitrage, there are professionals out there who see those price difference, and so they’ll keep buying gold in New York and selling it in London until the prices converge. That happens so fast that individual investors certainly can’t take advantage of it, a few very quick institutional investors can.

But if I told you as a value investor that you could buy gold in New York today and sometime in the next two or three years, it’s likely you’ll be able to sell it for a profit, but you may lose 40% while you are waiting around for that to happen, it’s much harder to find someone to arbitrage that away. Time horizons are actually shrinking over the last 20-30 years even. So, things are actually getting better for value investors, not worse. The world is becoming more institutionalized, there is more access to performance information, it’s much easier to trade. So, patience is in short supply, and it really makes it much nicer for patient value investors.

If value investing worked every day and every month and every year, of course, it would get arbitraged away, but it doesn’t. It works over time, and it’s quite irregular. But it does still work like clockwork; your clock has to be really slow. [5]

To conclude, high turnover hurts you everywhere with transaction costs internal to a given fund. Use ETFs when possible, particularly in taxable accounts, to delay capital gains distributions. And above all, be patient. In a world where everyone wants everything done yesterday, few have the wherewithal to hold an asset for 1 year let alone 5, 10 or 20. If you choose to go the route of owning an index fund of small company or value stocks make sure you’re in it for the long-haul. Holding period may be your best edge when it comes to these assets.

1. Banz, Rolf W. The Relationship Between Return and Market Value of Common Stocks. Journal of Financial Economics. 9-1981. pp. 3-18.
2. Fama, Eugene F. and Kenneth R. French. The Cross-Section of Expected Stock Returns. The Journal of Finance. Vol. 47, No. 2 (Jun., 1992), pp. 427-465.
3. Susko, Peter M. Turnover Rates and After Tax Returns. Journal of Wealth Management. Vol. 6, No. 3 (Winter 2003). pp. 47–60.
4. Bernstein, William. Value Stocks—Hidden Risk or Free Lunch?. September 1999.
5. D’Asaro, A.J. Greenblatt: Patience–the Secret to Value Investing. October 31, 2013.

What I’m Reading
Most of what you are going to do or say today is not essential (Farnam Street)
The worst mutual fund in history (Value Walk)
Why Passive Investing Increases Corporate Activism (Knowledge@Wharton)
11 signs that you own the right investment portfolio (Jonathan Clements)