Asset Class Investing: No Pain, No Gain

The value premium is one of the most well documented facts in finance. To calculate the value premium financial economists take the return of value stocks (defined as stocks within the top 30 percent of stocks ranked by book-to-market [BtM] value) and subtract the return of growth stocks (defined as stocks within the bottom 30 percent when so ranked). The term HmL—the return of high [H] BtM stocks minus (m) the return of low [L] BtM stocks—is the term used for the value premium. For the eighty-year period 1927–2006, HmL was 5.0 percent on an annual average basis. The annualized (compound) HmL was 4.3 percent.

With this knowledge, many investors deviated from pure market-cap weighted portfolios. Instead, they seek to capture the value premium by “tilting” their portfolios to value stocks. Investors who did so were rewarded with large premiums from 2000 through 2006. The premiums were 37.8, 14.5, 12.2, 3.0, 8.3, 8.3 and 12.7 percent, respectively. This produced an annualized premium of 13.4 percent. However, in 2007, the value premium turned sharply negative.

Tracking Error Risk

After years like 2007, when portfolios experience negative tracking error (when a portfolio underperforms a broad market index like the S&P 500 Index), many investors question their strategy of tilting to value stocks. Very few investors ever question their strategy when it generates positive tracking error. However, investors who tilt their portfolio to value stocks because they are trying to capture the value premium must accept the fact that there will be periods of underperformance. If they are not prepared for that, they should not tilt their portfolio in the first place.

Investors who are questioning their strategy, should ask themselves the following question: What has changed that would cause me to abandon my strategy? Those asking the question should consider that the most basic tenet of investment theory is that risk and expected returns are related. Value stocks have provided historically higher returns than growth stocks and stocks have provided higher returns than Treasury bills for the same reason—they are riskier. Because there is incremental risk, investors require a risk premium (higher expected return) as compensation.

The Nature of Risk

What is important to understand is that if value stocks always provided higher returns than growth stocks, there would not be any incremental risk. Thus, while investors should always expect that in any given year (or quarter or even month) value stocks will outperform growth stocks (because they are always riskier), the “price” of the higher expected return is that the investor must accept the risk that there will be periods when value stocks will actually produce lower returns. The logic is simple. If value stocks always outperformed growth stocks, there would be no risk, and hence no risk premium. The same is true of stocks relative to Treasury bills. The reason stocks have outperformed Treasury bills is that they are riskier and investors demand compensation. That compensation is called the equity risk premium. If stocks always outperformed Treasury bills, investing in stocks would entail no risk and there would be no risk premium.

Thus, the answer to the question, “What has changed,” is nothing. You decided to tilt to value stocks because being risky stocks they offered a risk premium (higher expected returns), and you were willing to accept that risk. Does the fact that they provided lower returns in 2007 than growth stocks mean that they now have lower expected returns than growth stocks? For that to be true you must believe that value stocks are actually safer than growth stocks, or risk and expected return would be unrelated.

Since the obvious answer is that nothing has changed, you should not change your strategy. Instead, you should take advantage of the opportunity to buy value stocks when they are on sale. You would do this by rebalancing your portfolio, restoring your asset allocation to the targeted level.

Bear Markets Provide Important Reminder

While painful to endure, bear markets (or simply periods of underperformance) are actually a good thing in one important sense. The reason is that if there were no bear markets and stocks were not volatile, risky investments, they would not provide a risk premium. (And the same is true of value stocks.) Periods like 1929–32, 1973–74 and 2000–02, when the S&P 500 Index lost 23, 21 and 15 percent per annum, respectively, are why equities have produced an annual risk premium of about 8 percent over one-month Treasury bills. But the standard deviation of that risk premium has been about 20 percent. Equity investing involves significant risk of large losses—if those bear markets didn’t occur, investors would not have earned those great returns that disciplined buy-and-hold investors were rewarded with because the risk premium would not have been there in the first place. Bad periods remind investors that there really is risk and that risky investments are priced to compensate investors for taking risk.

Returning to our discussion on value stocks, let’s look at some important data related to HmL.

The Value Premium

The value premium has appeared with a high degree of persistence—HmL was positive in 51 of the 80 years from 1927 through 2006, or 64 percent of the time. Of course, that means it was negative 36 percent of the time. That is the nature of risk.

• The standard deviation of HmL was over 2.5 times the annual premium at 12.7 percent. This high figure shows the risky nature of investing in value stocks. The highest HmL occurred in 2000, when it reached 37.8 percent. Ironically, the lowest occurred the prior year when HmL was a negative 26.1 percent (probably causing many investors to panic and sell).
• There have been relatively long periods where HmL has been both positive and negative. For example, in the five-year period 1927–31, HmL was negative in four of the five years. It was also negative in four of the six years 1934–39, three of the five years from 1949-53, three of the five years from 1956–60, four of the six years from 1966 through 1971, all three years from 1978–80, and five of the seven years from 1985–91. On the other hand, it was positive all nine years from 1940 through 1948, all five years from 1961 through 1965, all six years from 1972 through 1977, and all seven years from 2000 through 2006.

While HmL has been fairly persistent, there has been no predictable pattern to the premium. The only way investors could have reliably earned the value premium is if they had the discipline to maintain their exposure. This means that investors would have had to have ignored the clarion calls from Wall Street and the media that are often made after a few years of value outperformance. Calls like “This is the year of growth stocks,” had been heard almost continually since 2002.

Keep in mind what would have happened to investors who after experiencing the huge value premiums of the first three years of the new century (2000–02) when HmL was 37.8, 14.4 and 12.2 percent, respectively, listened to such calls and sold their value holdings to buy growth stocks. They would have missed the next four years when HmL was 3.0, 8.3, 8.3 and 12.7 percent, respectively.

The evidence from academic studies shows that there has been no persistent ability to time the market increasing equity allocations ahead of the bull emerging into the arena and lowering them ahead of the bear emerging from its hibernation or to shift allocations between asset classes. Consider the following example. A study of one hundred large pension funds and their experience with market timing found that while they all had engaged in at least some market timing, not one had improved its rate of return as a result. In fact eighty-nine of the one hundred lost as a result of their efforts, and their losses averaged an incredible 4.5 percent over the five-year period.[1]

There are two reasons that trying to time the market are unlikely to be successful. As we have discussed, ex-ante (before-the-fact) there should always be an equity risk premium because stocks are always riskier than one-month Treasury bills. All that high valuations predict is relatively low future expected returns; but those returns should still be higher than the returns on a riskless security. Second, the equity risk premium is so high that timing efforts would have to be right almost all the time to be successful. The same is true of the value premium.

Just as there is no evidence supporting the view that investors are likely to succeed in their efforts to time the market, there is no evidence that they can “time” the value premium with persistence. If there were, we would see evidence of active managers outperforming passive benchmarks with persistence greater than randomly expected. Yet, we don’t see such persistence.

There is an important fact about value stocks and their returns that investors should understand because it will help them ignore the media (and their friends). Most of the HmL premium comes from a small percentage of value stocks that produce very high returns. Their outperformance often leads to them “migrating” out of the value asset class, leaving a different group than the prior year. The same thing is true of small-cap stocks.

Even with this knowledge, there are those that believe the value premium can be timed based on the relative spreads between the valuations of value and growth stocks. In other words, when the spread between the book-to-market (or price-to-earnings) ratios of value and growth stocks is wider than the historical average, investors should load up on value stocks. On the other hand, when the ratio is relatively low, they should abandon value stocks and move to growth stocks. This would seem to make sense since studies have found that when the spread in book-to-market (BtM) ratios between value stocks and growth stocks is high, the subsequent value premium tends to be high. The reverse is also true.

Evidence on Trying to Time the Value Premium

Based on that information, if next year’s value premium is expected to be high, it would seem logical to own value stocks. If it were expected to be low, then growth stocks would seem to become the logical choice. Is it really that simple to earn abnormal returns? Does a statistical relation always translate into a viable portfolio strategy? These are the questions Jim Davis asked and answered in his 2007 study “Does Predicting the Value Premium Earn Abnormal Returns?”[^2] The study covered the period July 1927–June 2005.

Davis found that style-timing rules did not generate high average returns despite having future information about BtM spreads. In fact, he concluded that that the expected excess return of style timing is probably negative—for the same reasons that efforts to try to time the overall market are likely to fail. Just as there should always be an expected equity risk premium, ex-ante there should always be a value risk premium. And as is the case with the equity risk premium, the value premium is so large that any trading strategy would have to be right almost all of the time to deliver successful results. It would be like switching from the high-speed carpool lane to the center lane on a crowded freeway. Your “freeway algorithm” might help predict when the carpool lane or center lane will move faster or slower than normal. But will it be accurate enough to justify switching into the slower lane in an effort to get there quicker? The evidence suggests that you are better off staying in the carpool lane. The lesson for investors is that the existence of a statistical relation does not necessarily imply that a profitable trading strategy based on that relationship exists, especially after accounting for trading and other costs.

Summary

Investors in high-returning asset classes should not be surprised when the risks show up. Instead, they should be pleased that it does show up occasionally because otherwise they would not have the opportunity to earn the expected risk premium. Of course, experiencing periods of underperformance and bear markets are painful, but there is an old adage that seems appropriate—“no pain, no gain.”

One of the important keys to financial success is having knowledge of financial history. Those that do not know that there will inevitably be periods of underperformance may fall prey to tracking error risk and abandon their plan. But investors that have the knowledge history provides are forewarned. Thus, they will be more likely to have the discipline to stay the course. In fact, disciplined investors look at periods of underperformance as opportunities to buy stocks when they are on sale. In other words, the market is a mechanism that transfers wealth from those with a strategy and strong hands to those without one and weak hands.

The bottom line for investors is that the prudent strategy is to ignore the calls to alter your investment plan that you hear, be they from your stomach, Wall Street or the financial media. The only actions you should be taking are rebalancing your portfolio and harvesting losses for tax purposes. Those that have the discipline to stay the course will avoid the fate of the typical investor who underperforms the very mutual funds they invest in by a significant margin (because they keep altering strategy and chasing past returns).^[3]

Footnotes

1. Charles Ellis, Investment Policy (Irwin Professional Pub 2nd edition 1992).

2. James L. Davis, “Does Predicting the Value Premium Earn Abnormal Returns?” January 2007.

3. Morningstar FundInvestor (July 2005).

Larry's opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management.