When trying to build a balanced portfolio, investors have been torn between competing philosophies, such as value versus growth and large-cap versus mid-cap versus small-cap. When evaluating these strategies, there is a tendency to base decisions on total return, but in my opinion, "return" is only one side of the coin. Investors should be equally concerned with risk. This article will evaluate growth and value portfolios over multiple time frames in terms of reward-to-risk ratios. Along the way I will also assess how capitalization (large, medium, and small) affect the performance of these growth and value oriented funds.
Standard and Poor's has developed a wide range of indexes that are widely used as benchmarks for ETFs and mutual funds. The indexes used in this article are:
- The S&P 500 Index. This index focuses on the large-cap sector of the market. The constituent companies each have a market cap of over $4.4 billion. In total, this sector comprises about 75% of the total value of the domestic equity market.
- The S&P Mid-Cap 400 Index. The index represents the mid-cap (market cap between $1 billion and $4.4 billion) range of companies. In total, mid-cap companies represent about 18% of the domestic market's value.
- The S&P Small Cap 600 Index. This index is comprised of small companies, each with a market cap between $300 million and $1.4 billion. This sector represents the remaining 7% of the domestic market's value.
The ETFs that I analyzed were based on these Standard and Poor's indexes. There are similar ETFs that I could have used but these have been around the longest (launched in 2000) and all have reasonable liquidity, with an average trading volume of at least 100,000 shares per day. The ETFs are:
- iShares S&P 500 Value (IVE). This ETF tracks the third of the S&P 500 stocks that have been assessed as "value" stocks based on attributes such as price to book, price to earnings, and price to sales.
- iShares S&P 500 Growth (IVW). This ETF tracks the third of the S&P 500 stocks that have been assessed as "growth" stocks based on attributes such as increases in sales and increases in earnings.
- iShares S&P Mid-Cap 400 Value (IJJ). This ETF tracks the third of the S&P Mid-Cap 400 stocks that have been assessed as "value" stocks based on attributes such as price to book, price to earnings, and price to sales.
- iShares S&P Mid-Cap 400 Growth (IJK). This ETF tracks the third of the S&P Mid-Cap stocks that have been assessed as "growth" stocks based on attributes such as increases in sales and increases in earnings.
- iShares S&P Small-Cap 600 Value (IJS). This ETF tracks the third of the S&P Small-Cap 600 stocks that have been assessed as "value" stocks based on attributes such as price to book, price to earnings, and price to sales.
- iShares S&P Small-Cap 600 Growth (IJT). This ETF tracks the third of the S&P Small-Cap 600 stocks that have been assessed as "growth" stocks based on attributes such as increases in sales and increases in earnings.
To evaluate the risks and rewards of these ETFs, I plotted the rate of return in excess of the risk free rate (called Excess Mu on the charts) versus the volatility of each ETF. The results are shown in Figure 1 and were generated using the Smartfolio 3 program (smartfolio.com). The data covered two complete bull-bear market cycles from July, 2000 to the present (almost 13 years). Value oriented ETFs are denoted by "green dots" and growth by "red dots". The symbols L, M, and S refer to Large-cap, Mid-cap, and Small-cap respectively.
Figure 1: Risk vs. Reward since July 2000
Several observations are evident from Figure1. For each class of capitalization, the "value" category yielded a higher return than the "growth" category but with a slightly increased volatility. The fact that "value" had a higher volatility than "growth" was counter-intuitive since growth is usually associated with more volatility. Was the increased return associated with "value" worth the increased volatility? To answer this question, I calculated the Sharpe Ratio for each ETF.
The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk.
For each capitalization class, the Sharpe Ratio for the associated "value" ETF was higher than that for the "growth" ETF. So we can conclude that over the two market cycles since 2000, "value" ETFs have delivered better risk adjusted performance than "growth" ETFs.
The analysis becomes more interesting when we compare performance among the capitalization classes. The conventional wisdom is that small-caps are the most volatile class and this belief was validated by the data. The Sharpe Ratios associated with small-caps were larger than the corresponding ratios for large caps. Thus, the small-cap rewards were indeed worth the risk (over large caps).
Mid-caps also exhibited a better reward-to-risk when compared to large-caps. However the performance of mid-cap ETFs was more of a mixed bag when compared to the performance of small-caps. The mid-cap "value" ETF had the best Sharpe Ratio but mid-cap "growth" did not perform as well as small-caps.
Some pundits have suggested that you should purchase small-caps funds to diversify your portfolio. Unfortunately, the data does not support this strategy. As shown in Figure 2, all the ETFs are highly correlated with each other. Thus, purchasing more than one of these ETFs does not offer much in the way of portfolio diversification.
Figure 2: Correlation Matrix for ETFs (July 2000 to present)
To see if this long term trend has continued into the more recent past, I analyzed the performance of the same ETFs over the last bear-bull cycle that began in October, 2007. The results are plotted in Figure 3.
Figure 3: Risk vs. Reward since October 2007
Some of the previous observations remain the same. Small-caps are generally more volatile than large-caps and the mid-caps and small-caps handily beat large caps on both a total return and a risk adjusted basis. Also, for each capitalization class, "value" continued to be more volatile than "growth" and all the ETFs also continued to be highly correlated with one another.
However, there were some major differences. For each capitalization class, growth now beats value-the opposite of the previous conclusion. The best performer on a risk adjusted basis over this period was again mid-caps, but this time it was mid-cap growth rather than mid-cap value. Small-cap growth had the second best Sharpe Ratio. Even though "growth" now beats "value", it should be noted that the mid-cap and small-cap value ETFs were not far behind.
For the last analysis, I decided to see how these ETFs performed in a rip-roaring bull market, so I chose data from March 9, 2009 to the present. The results are shown in Figure 4. The rates of returns are tightly bunched and the Sharpe Ratios are very close to one another (except for small-cap value which has a slightly lower Sharpe Ratio). Thus in the latest bull market, on a risk adjusted basis, you did well regardless of which assets you chose.
Figure 4: Risk vs. Reward since March, 2009
The bottom lines observations from this analysis are:
- Value ETFs were more volatile than growth ETFs
- Small-caps were more volatile than large-caps
- Small-caps and mid-caps had similar volatility
- Assets with different capitalizations do not offer substantial diversification, nor does choosing between value or growth. All the ETFs in this analysis were highly correlated among themselves over all the time frames studied.
- Mid-caps and small-caps beat large-caps in terms of both return and Sharpe Ratio.
- Unfortunately there was no definitive answer as to whether value is better than growth. I was not able to detect any clear trend; the results depended on the time period under analysis.