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The academic case for using a multi-factor model to maximize the realized equity risk premium is old news, but documenting the empirical evidence is forever new. It's been known since the 1970s that the single-factor model of CAPM doesn't fully explain the risk-return relationship for stocks. The limitation of the one-beta model has inspired a range of nuanced approaches for modeling returns and looking for Mr. Market's silver lining. The most popular framework is still the Fama-French 3-factor model that taps the broad market beta along with the small-cap and value factors. It's useful every once in a while to ask: How's the 3-factor recipe working out for 'ya. As it turns out, quite well, or so recent history suggests.

There's always some doubt if the small-cap and value factors will deliver a risk premium through time. Why? Limited capacity. There's only so much room in these slices of the equity market and if too many investors pile in the expected return will fade if not evaporate entirely. Indeed, there have been stretches when holding small cap and/or value has been a dog--the late-1990s, for instance. The optimistic view is that if you're patient, and can tolerate higher risk, you'll be rewarded eventually. More ambitious types recommend some market-timing and adjusting the small-cap and value asset allocations through time based on changing expectations.

So, what does history tell us? It's clear that over multi-decade periods the evidence supports the small-cap and value strategies. But what about recent history? The last 10 years suggest that the small-cap and value factors are still alive and kicking, as the table below shows:

011712a1.GIF

Note that the small-cap value (Russell 2000 Value) and microcap value (Russell Microcap Value) indices are comfortably in the lead for the past 10 years through January 17, 2012. The Russell 2000 Value has generated a 6.7% annualized total return for that decade, or nearly twice the 3.7% gain for the broad large-cap equity market (Russell 1000). It's also notable that within large-cap, value beat growth.

You can't count on the small-cap and value factors in the short term, and perhaps not even in the long run. The future's always uncertain and the associated risk premiums are empirical "facts." But for the moment, those "facts" look persuasive. Deciding if they'll remain persuasive is closely related to how many investors agree and decide to hold above-market-weight allocations in these equity groups.

Source: Data Check: The Small-Cap And Value Factors