Capturing Factor Premia: Part III, The Market Premium

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Includes: DFQTX, VFIAX, VTSAX
by: EB Investor
Summary

In my previous two pieces on capturing market premia, I explored the size and value factors.

In this piece, I will go back to the beginning and explore the dynamic nature of the market factor.

I will explore what vehicles are best for capturing the market factor.

There is a constant debate going on about how best to invest in the passive space. One group declares that the three fund index portfolio is superior, capturing the full market, and all factors in it. Yet, others make the case that over weighting ones exposure to small cap and value stocks, among other factors can lead to market beating performance over the long run. Regardless of who is correct, both groups would agree that over the long run, stocks offer a superior way to build wealth, than one can attain in the risk free rate.

While I have explored both the size and value premia in parts one and two of this series, I want to conclude the series where it all begins, and take a look at the market premium. Specifically, I want to explore why the market premium is the greatest of all, and why this decision alone, can have a profound impact on your wealth building.

How Do Markets Work?

The question of how markets work is a fundamental principle of being able to invest effectively across your life time. Many investors subscribe to the notion that market prices can create distortions, and active managers can capture those disconnects between price and value. Academic research however, completely rejects this idea. According to research there is no disconnect between price and value. Something is worth the price at which a buyer is willing to pay. In this way, market participants can trust the prices they pay because market prices reflect all, known, available information. This is known as an efficient market, a market that efficiently absorbs new information as it comes into a marketplace. For example, when a market price declines substantially, after a company states on an earnings call that they will earn less money in the coming quarter, the market incorporates this information into the stock price, bringing it down to where the market believes the company should trade. This is now their new value, and the only way to move the stock in either direction is through the incorporation of new information.

It is precisely because markets are efficient at incorporating new information into stock prices that, we as investors, have no advantage in engaging in stock picking or other activities aimed at outperforming the market. Those who buy individual stocks in the hope of some event in the future, are gambling on the price of the stock. In any given year, you may outperform, market perform, or under perform a given market average, but it is random, and not the result of an individuals ability to apply securities analysis activities.

Some of the best investors are correct in their forecasts about the amount of times we would expect from mere chance, as this chart from IFA indicates. If these investors with all of their sophisticated degrees, certifications, and experience are not able to routinely pick stocks that beat the market, what do you think are the chances of the average investor?

The fact is that Wall Street is very smart. Every year the best investment companies in the world recruit the best of the best out of the top schools in the world for finance. When you sit at home with your brokerage account and think you are smarter than this group of highly educated experts with every professional tool at their disposal, or that you have an edge over them, you are deluding yourself.

Spencer Jakab wrote a book on this very subject called, Heads I Win, Tails I Win, which was profiled in the Wall Street Journal under the heading "Why You're a Lousy Investor and Don't Even Know It". Stating " the “average” investor lags the average return by four to seven percentage points per year...Investors are constantly under the false impression that they or some vaunted expert knows something that will help them gain an edge." But research tells us that investors who engage in these activities are likely to suffer large gaps between their returns and the returns of the market.

In other words, engaging in market timing, active management, and other speculative investment activity in an attempt to gain an edge is more likely to harm your returns rather than enhance them. Capturing the market premium over the risk free rate, is as simple as buying and holding the market.

Image result for behavior gap returns 2017

What Is The Market Premium?

The market premium is the amount one can earn over the risk free rate by investing in the market index, vs. simply holding t-bills. The fundamental challenge with this is that, in the short run, one has no knowledge of what the market will do. Similarly long run averages are the best method we have to estimate the market premium. It is possible that over any period of time, any factor, including the market premium, can fail to show up. We saw this in the 2000-2010, lost decade for stocks, where a simple Treasury portfolio would have outperformed stocks. However, the key is not to focus on any single year, or even decade, those who are investing for long term goals need only focus on a 20-40 year time frame or even longer in some cases.

Dr. Aswath Damodaran at New York University has compiled the annual returns through 2017 for both long and short term bonds, as well as the S&P 500 index. In reviewing the data we see a robust and defined premium for those who chose to hold stocks, rather than either maturity of bonds.

Arithmetic Average S&P 500 (includes dividends) 3-month T.Bill Return on 10-year T. Bond
1928-2017 11.53% 3.44% 5.15%
1968-2017 11.41% 4.82% 7.17%
2008-2017 10.27% 0.42% 4.29%
Geometric Average S&P 500 (includes dividends) 3-month T.Bill Return on 10-year T. Bond
1928-2017 9.65% 3.39% 4.88%
1968-2017 10.05% 4.77% 6.76%
2008-2017 8.42% 0.41% 3.86%
Risk Premium (Arithmetic)
Stocks - T.Bills Stocks - T.Bonds
1928-2017 8.09% 6.38%
1968-2017 6.58% 4.24%
2008-2017 9.85% 5.98%
Risk Premium (Geometric)
Stocks - T.Bills Stocks - T.Bonds
1928-2017 6.26% 4.77%
1968-2017 5.28% 3.29%
2008-2017 8.01% 4.56%

As you can see, the risk premium for stocks over bonds during all of these periods is quite substantial. While the past is no indication of the future, we can make an educated assumption that the odds of stocks beating bonds over the course of time, is statistically in our favor. This is because for every unit of risk that we take there is a level of return investors can expect from the market for taking that risk. The risk that equity investors take over the risk free rate of Treasury bonds, is what is known as the equity risk premium, or the market premium.

Capturing the Market Premium: Methodology Matters

So you are convinced that markets are efficient, and that investing in the stock market will yield you a long term premium return over what can be achieved in the risk free rate of Treasury bonds, but how do you go about actually capturing that return? The first, and best decision every investor needs to make is to begin their investment portfolio with a broadly diversified total market index. Many have questioned what index is best. The old dilemma here is typically choosing between a total market index or an S&P 500 index for the core of their portfolio. Allan Roth wrote a rather compelling piece at Marketwatch for why investors should avoid the S&P 500 and choose the total stock market index, instead.

I ran the data looking at a number of solutions to capturing the market premia. The results show that each option demonstrated fairly consistent returns over a short period that was available to track. Additionally, we see that when we segment different periods in time, various approaches are able to capture more of the market premia because of their additional exposure to beta (market risk factor).

Fund # Holdings

Cumulative Returns 2008-2018

Vanguard Total Stock Index ADM (VTSAX) 3,638 181%
Vanguard S&P 500 Index ADM (VFIAX) 500 178%
Fidelity Total Stock Market Index PREM (MUTF:FSTVX) 3,335 179%
DFA Core Equity II (DFQTX) 2,795 177%

It would appear at first glance that the Vanguard Total Stock Market Index was the best vehicle for capturing the market premium. It holds more stocks than all the other index options, and produced a higher total return. However, it should be noted that when we remove the 2008 financial crisis numbers, and tested the data during the recovery period of March of 2009, to the Present, the DFA fund outperforms. DFA Core Equity II produced a total return from the market bottom to the present of 436%, the Vanguard Total Stock Index returned 401% during the same period. This is because the DFA fund had far more exposure to beta than the other market index funds, as a result of DFA's approach of tilting towards the five factors of outperformance (market, size, value, profitability, and investment). It is equally important to remember that the exposure to beta is a double edged sword, increased exposure to beta works on both the up and the downside.

Conclusion

Overall the Vanguard Total Stock Index is a fine choice for anyone looking at capturing the market premia. However for long term investors, I would prefer the multi factor approach of DFA, which may afford investors a cost effective and systematic methodology to beat the market over the long run. For investors without access to DFA funds, which are only available through approved financial advisors, combining the total market index with the new Vanguard Multi-Factor Fund (VFMFX, VFMF) is an interesting alternative for investors to consider. In the end, the most important learning for investors is the vast power of markets, and the power of the stock market to build wealth for you. Passive investors whether through factor or straight indexes stand the best chance of capturing the full market premium, because they acknowledge the wisdom of the market is greater than their ability to chase stocks, and they allow the profits and dividend income of capitalism to flow to them.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is for informational purposes only and is not an offer to buy or sell any security. It is not intended to be financial advice, and it is not financial advice. Before acting on any information contained herein, be sure to consult your own financial advisor. This article does not constitute tax advice. Every investor should consult their tax advisor or CPA before acting on any information contained herein.