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Paul Merriman: The One Asset Class Every Investor Needs
What do you all think of this? I've been noticing that registered investment advisors far and wide have been touting small cap value indexes more and more. My primary index fund is the total stock market index fund. Merriman, Larry Swedroe and a ton of others tout the small cap value index.
Would love to hear the opinion of MFOers.
Dimensional Fund Advisors has a lot of influence, and they favor value; small cap; small cap value; and more recently there are a couple of additional factors they are tilting toward.
Those of you who are index fund fans, are you emphasizing small cap value?
@davidrmoran, Morningstar lists WEMMX as a small cap blend, and the portfolio P/E ratio of 20 [19.99] seems to support that it is not a small cap value fund.
In the linked article, Paul Merriman is recommending small cap value, not just small caps in general
Oh, I know, one of the drawbacks of the article (and a bit with M*'s hairsplitting classifications). One reason I always dig deeper. I always look at the blend categories whenever I am analyzing value behaviors and records.
Look at it this way. Graph performance since, say, spring of 1999. P/E and lower divs aside, WEMMX exactly equals performance of the mighty DFSVX --- except for notably better (smoother) dip performance in 02 and 08. Wow. It also clobbers VISVX for the same 15y period, again with half the dip or better.
The 10y graph is, ow, even more dramatic, really significant outperformance, Gabelli tripling, compared with 2.5x for the other two ... and perhaps a third of the dip in 08 with much faster recovery. One team the whole time.
You can readily concoct similar odd comparisons with other SC nongrowth funds. These three are all 4*, Merriman's love of the two cited notwithstanding.
So: in this case the vaunted SCV designation gave you considerably, consistently rougher and bumpier performance for significantly inferior outcomes compared with SCB. What does that tell us? (Hasty second example: compare 10y outperformance, smaller but with identical 08 dip, of small-blend index NAESX vs VISVX.)
Yes indeed, a Small Cap Value mutual fund is a valuable holding within a portfolio. It adds robustness to the portfolio with its diversification attribute and its incremental excess returns (something like 2%) above large cap equity holdings.
This is not a new finding. Folks have been exploiting its benefits for two decades. The original research that identified its benefits was generated in 1992 by the Fama-French University of Chicago academic team. Their model is called the Fama-French Three Factor model.
The signal paper is titled “The Cross-Section of Expected Stock Returns”. It was published in the Journal of Finance. The 3-factor model includes Bill Sharpe’s market Beta term, but was expanded to incorporate a small cap component and a low price-to-book ratio value component. It represented the first perceived shortcoming in Bill Sharpe’s CAPM model.
Here’s a Link to a reasonable summary of the Fama-French work:
As the article stated, Fama-French is a better mouse trap (but still imperfect). That discovery shocked some nonscientists. That’s an overreaction. Models are simplifications that incorporate assumptions and constraints; consequently, they are almost never perfect. That’s especially true for disciplines like economics and finance which are strongly influenced by behavioral biases and emotions which are dynamically sensitive to a host of factors.
Paul Farrell’s 8 Lazy Portfolios have practically implemented the Fama-French research in their Index heavy portfolios. Just scan these 8 portfolios, all assembled by acknowledged financial wizards, to judge its near universal acceptance. Here is the Link to Farrell’s frequently referenced scorecard:
I have been using the Fama-French work for two decades using a mix of both actively managed and passive Index mutual fund products. The obvious Index choices are Vanguard entries: Vanguard Total Stock Market Index Fund (VTSMX) and Vanguard Small-Cap Value Index Fund (VISVX).
The total stock market fund includes a fair share of small cap components, but adding the focused small cap value holding adds weight to keep portfolio returns high while slightly reducing its overall standard deviation.
The longer term (since 2000) correlation coefficient between the two Vanguard indices is 0.93; a shorter term (dating from 2012) correlation coefficient is 0.95. This minor correlation coefficient disparity between these two funds doesn’t significantly impact portfolio standard deviation, but the historical excess returns is worth pursuing.
By the way, Fama and French are currently pushing an improved 5-factor model. And so research continues……. So you have assigned yourself a never ending task. Good luck and good hunting.
@MJG: thanks very much. I'm going to read the references you linked and hopefully reply again
@prinx: thanks. That Vanguard's modus operandi. They often have an investor share class, with a $3,000 minimum, and relatively higher expenses; an Admiral share class with a higher minimum and much lower expenses; and an exchange traded fund version with the same very low expenses as the Admiral shares version and of course no minimum. The Vanguard Small Cap Value Admiral and etf version have an amazing expense ratio of just 9 basis points, .09%. The Admiral shares have a $10,000 minimum purchase to get in.
One thing I don't care for in the Vanguard Small Cap Value: the stocks are too large. The average market cap of the stocks: 2,798 million I much prefer the DFA US Small Cap Value I DFSVX average market cap of 1,294 million Much smaller stocks, much preferred imo for this specific purpose.
Unfortunately I have no access to DFA funds without paying for a registered investment advisor, which I have no need for at all, other than to get me into the DFA funds!
Not to flame another Cman/MJG war, but there is definitely another side to this story. Fama-French factors have come into some pretty compelling criticism lately, and it is no longer clear there is a SCV premium or historical outperformance.
First, a graphic example. (edit: Sigh, looks like M* won't allow you to link to the period I had originally input. To look at that chart, use 6/25/1979 as the start date. The values I listed are correct.)
Those are the returns of a $10,000.00 investment in each of VFINX ($474,278.66), NAESX ($434,025.38), SCV ($524,319.28), and LCV ($411,828.31) over the past 35 years, approximately the time horizon of a retirement portfolio.
Second, the CAPM model assumes the most efficient portfolio is one that contains all the securities in a market, and that any excess return comes from increased risk. Fama-French expands that by explaining where you find that risk (beta). You aren't increasing your diversification by adding SCV to a portfolio of domestic stocks (if you doubt this, check a correlation table between VFINX and VISVX). You are adding risk in hope of greater returns.
So two questions: 1) Where are the excess returns for the small cap and value premia; and 2) if this investor didn't get greater returns, why did he/she accept greater risk?
As a lot of us probably know this, I'll just link these articles and let people ruminate on their own.
Sam Lee from M* explains Fama-French factors well here and here. He also explains his problems with Efficient Market Theory here. You can find the original paper describing the small-cap premium by Rolf Banz here.
Turns out, however, that there has been no return premium for small cap stocks since the data was gathered by Banz in 1979. How can that be? Explanations for problems with the Fama-French assumptions, start with their own recent paper explaining how the three factors are actually five. Ask yourself after, "where does this stop?"
From there you can read:
Sam lee on the Five-Factor model. ("I think this should be a come-to-Jesus moment for those who've taken the F-F model as the gospel truth. Fama and French admit that their original three-factor model was not motivated by theory. They chose value and size because they worked better than other characteristics in back-tests. Grounded in the efficient-market hypothesis, they came up with risk-based stories for these patterns. Small-cap stocks provided excess returns because they're more vulnerable to the business cycle. Value stocks did so because they were distressed.
However, since then, the size factor is no longer considered a significant source of excess returns by many academics and practitioners. Rolf Banz's original 1981 study showing a huge size premium was marred by survivorship bias. After it was corrected in the mid-1990s, back-tests showed a much smaller premium. Moreover, whatever excess returns small-cap stocks provided were driven by the smallest, least liquid securities.")
John Rekenthaler on problems with supposed historical premia. ("To the extent that smaller companies do outperform, those gains likely owe to a liquidity premium. Smaller-company shares have lower trading volume, which increases the chance of moving the stock price by putting in a trade order, and which hampers the investor’s ability to rapidly enter or exit a position. Low liquidity is a real cost that deserves to be compensated with a real return. This is fine--but properly speaking, it’s not a small-company effect.")
Finally these are articles from Advisor Perspectives, a commentary/newsletter service for FAs: 'The Small Cap Falsehood' ("The supposed outperformance of small cap stocks is a foundational precept on which many respected asset managers have staked their expertise over the years – foremost among them, Dimensional Fund Advisors (DFA), the famed fund company that has gained a near-religious following since they popularized small cap indexing three decades ago. A growing body of research, however, shows no such advantage for the last 30 years and, now, a new study seems to have proven that the supposed small-cap advantage may have never existed in the first place.");
and 'A Test for Small Cap and Value Stocks' ("In a recent talk, Stanford professor and Nobel economist Bill Sharpe challenged advocates of smart-beta strategies, including overweighting small-cap and value stocks, to respond to two questions. Can the strategy be adopted by all market participants, or does it have a practical limit in terms of assets that can be invested? If it has a practical limit, then one should expect the premium to decrease over time.
For small-cap stocks, for example, it is obvious that the answer is "no" – eventually the dollars pursuing those stocks would make them mid- or large-cap stocks. The same is true for value stocks; the money pursuing them will eventually drive prices up and erase their risk premium.
In an email exchange, [Larry] Swedroe essentially agreed.")
It should be pointed out that Merriman has an agenda here: he sells DFA funds that are uniquely based on the Fama-French factors. To be fair, those funds have done very well since inception. It is worth asking, however, if the small cap premium is based in liquidity and not size, whether an index is the best method of including this asset class in a portfolio.
It should also be said that the one factor that is predictive of future performance is valuation as measured by Shiller CAPE. And right now, US small caps have historically high valuations.
So should someone include SCV? That depends on what their horizon and goals are. But if they do weight to SCV, they should be aware they are accepting increased risk with no guarantee of increased returns.
Are we going to repeat history here? Does anyone remember about 20 years ago when the Dogs of the Dow investing strategy became very popular? Books and articles came out showing that if you just invested in the 10 highest dividend yielding stocks of the Dow 30 on the first day of the year, held them one year, then rebalanced into the new 10 Dow "Dogs", and repeated this process every year, you would have beaten the indexes soundly.
The major full service brokerages all came out with Unit Investment Trusts that held the 10 Dow Dogs and rebalanced into the new 10 Dow dogs the first day of each year. Mutual funds came out that focused on the strategy of the Dow dogs and modified the strategy. New versions came out, such as just investing in the top 5 dividend yielding Dow stocks. Then the strategy was applied to other indexes besides the Dow, foreign indexes, etc.....
Is small cap value investing going to become the new Dogs of the Dow? Will it crescendo in popularity until everyone knows about the supposed superiority of investing in small cap value?
And as it gets pushed by more and more registered investment advisors and market 'experts', how long will it take before the outperformance weakens? Will it one day turn into underperformance?
I've got no horse in this race. Just a student of the markets, trying to learn more and more.
bee, not sure what you mean by "but they perform in the relative space." Looks like VHCOX is a large cap growth fund per M*, with only 1% of its assets in small cap value. POAGX looks to be a midcap growth fund, and also has only 1% of its assets in small cap value, but does have 26% of its assets in the small cap growth space.
Wrt "keep in mind that successful SCV funds pretty quickly become categorized as MCV funds." This can certainly happen, especially if a fund, by virtue of its success, has a large increase in asset base, making it difficult for the fund to stay in the small cap space. My guess is this may have happened with Fidelity Low-Priced Stock FLPSX, which is now a midcap fund, although I don't have data from when the fund started out.
I think one can probably rest assured that a SCV index fund will stay true to its SCV space.
One SCV fund that caught my attention is Bridgeway Small-Cap Value BRSVX, which has an average market cap of 1,149 million and has been around since 2003. Interesting that the P/E ratio is only 15, and low P/B, showing its value nature. Bridgeway has some interesting funds. They also have a fund, Bridgeway Blue Chip 35 Index BRLIX, with a 174 billion dollar average market capitalization!
They have another even more interesting SCV fund, Bridgeway Omni Small-Cap Value N BOSVX, with an average market cap of only 662 million, and a P/E of 14. I'd be most interested in that one, but it looks like it is only open to financial advisors and their clients.
>> But if they do weight to SCV, they should be aware they are accepting increased risk with no guarantee of increased returns.
I do love theoretical argument, especially by academics, but hey, I have an idea instead: Go to M* 10k growth and chart VFINX, GABEX, GABSX, and WEMMX for 5-6-7-8-9-10y, and then max to 1998.
Report what you see then and tell how it fits in with all these theories. (I chose the last three cuz it's the same guy and team, of course.)
And/or someone could just do the charting of my earlier post above.
@mrdarcey: thanks for your exceptional post. A treasure trove of excellent resources.
@MJG: thanks for the excellent resources you provided.
Let me contribute a resource that I just uncovered. I've been wanting to know what John Bogle thinks of this whole thing. And it doesn't hurt to know what Professor Burton Malkiel thinks of it as well. Luckily, they joined in and co-authored an op ed piece on the subject that I just read a few minutes ago, and it's well worth reading for anyone interested in this subject:
I do love theoretical argument, especially by academics, but hey, I have an idea instead: Go to M* 10k growth and chart VFINX, GABEX, GABSX, and WEMMX for 5-6-7-8-9-10y, and then max to 1998.
Report what you see then and tell how it fits in with all these theories. (I chose the last three cuz it's the same guy and team, of course.)
I'm sorry if I wasn't clear. My post was meant to be an anti-academic/theory one, or at least anti-bad-academics. I do love me some Robert Shiller. Paul Merriman and MJG are convinced by the Fama-French arguments. I am skeptical and tried to present the other side of that story.
Comparing the 10-15 year returns of certain active funds with that of the S&P is a bit apples to oranges. I'm with you that active management provides downside protection and the possibility of better returns. But the question was "does SCV provide better returns?"
Over the last 15 years, the answer has been yes. But look back to valuation levels in 1999. The nature of market-cap weighting meant the S&P was full of overvalued tech stocks waiting to crash, while small value stocks languished. Savvy, patient managers were able to provide great returns when that bubble broke. But those conditions do not exist today. As an example, look at the returns of $10,000.00 for VFINX ($136,691.30 or 19.05%) vs. NAESX ($48,688.57 or 11.13%) over the previous 15 years, 6/26/1984 - 6/26/1999. Incidentally, the Tech and Japan Bubbles are my arguments #1 and #2 against market-cap indices.
That's why I gave 35 year returns of four distinct equity areas. 1979 was chosen for three reasons: First, 35 years is a long enough time to start to be statistically significant; second, 35 years is a fair approximation of the horizon of a retirement savings plan; Third, the evidence that small-cap stocks outperform was taken from the Rolf Banz 1979 paper using data from 1936-1975.
Over the past 35 years, the returns were: VFINX = 11.66% NAESX = 11.37% M*'s LCV tracker = 11.21% M*'s SCV tracker - 11.98%
Banz's paper was subject to later revision when people realized he hadn't accounted for survivorship bias. But that didn't stop Fama and French from harping on about the size premium, and how you get compensated for increased risk. And now they've gone back and admitted they just kind of made that up, but, hey, here's a whole new model!
Like I said, I'm skeptical of indexing in this space. If the small cap premium is actually just a liquidity premium, then what one should be looking for is actually microcaps, which I suspect actually do behave rather differently than larger equities and might help diversify. But that same lack of liquidity makes it awfully hard to index.
BRSIX is a sort of microcap index that seems to do well and that I've considered. For now, though, I just let the nice folks at Grandeur Peak handle this for me. Growthier, sure, but you can't beat the exposure to globally local microcaps. Perhaps their eventual fallen angels fund?
Is it not a rule in the markets, that when a simple way to invest to gain out-sized returns becomes widely known, that advantage is no longer seen in the future?
This is not a rhetorical question.
It is very easy to invest in a small cap value index. It takes no skill, knowledge or abilities. Supposedly that has produced significant out-sized returns in the past. Is there any reason to believe this pattern will continue into the future, since it is now well known?
What works on Wall Street is not constant. That’s why the super quants who currently run the most successful Hedge funds are so secretive about their methods and must use the highest speed computers to find and to exploit the market inefficiencies.
Folks have been learning this investment lesson forever. Jesse Livermore never revealed his secrets and continuously revised them based on present conditions.
In 1996, James O’Shaughnessy wrote a book titled “What Works on Wall Street” after much research. It was celebrated as the most influential investment book over decades. When O’Shaughnessy initiated a mutual fund to put his findings into practice, it failed miserably. He sold the fund, and the methods he discovered generated excess returns for a period thereafter. Investment strategies come and go and often return. These things are highly transient.
Risk and reward are tied at the hip, but with a bungee cord so that departures in time and space are variable and unpredictable. But the cord does exist. It is captured in the Wall Street rule of a regression-to-the-mean.
Each investor gets to choose his own risk level. As Ben Franklin said: “He that would catch fish, must venture his bait”. More recently, Nassim Taleb observed: “Risk taking is necessary for large success – but it is also necessary for failure”. You get to pick where on the risk spectrum your portfolio is positioned.
There are no free lunches. The marketplace is not a perfect measuring machine and is never in equilibrium. Markets move in that ideal direction, but never quite get there. Some exogenous event disrupts the process. Physically, it’s like an agitated coiled spring that is slowing down to an equilibrium, but gets an unexpected push. Opportunities present themselves but are extremely transient. Hard work is the price to identifying opportunities.
Two themes that run throughout Scott Patterson’s excellent book “The Quants” are the secret, competitive nature of its participants, and the need for hypersonic speed. The market pricing dislocations don’t persist. For these wiz-kids, The Truth is an elusive target. Emotions are high and disaster is always near, especially when excessive leverage is deployed to magnify small percentage profits into outsized wealth.
Many long-term players say investing is conceptually easy, but difficult to execute. When David Swensen was writing “Unconventional Success”, he changed the entire format of his book to advocate an Index approach when he realized that the average investor had neither the time, knowledge, or resources needed to execute the strategies deployed by successful professionals.
In the business world size does matter.
A reasonable analogy is the human lifecycle. A vibrant adult (a mature business) is better equipped to endure and survive “the slings and arrows of outrageous (mis)fortune” than a baby (an upstart business).
Again, historically investment asset classes do have a pecking order in terms of expected returns with anticipated risk factors. Typically, but not always since the marketplace can be wild and illogical for excruciatingly long periods, Small Cap rewards are expected to outdistance Large Cap returns. The historical data generally supports this proposition.
Although Small Caps are often expected to deliver about 2 % incremental returns over their Large Cap brethren, current investor perceptions that are both factually and emotionally driven do distort these projections. Why?
Small size often makes the company more vulnerable to unexpected perturbations. Typically their product line is more focused and not as diverse as a Large firm. Another risk factor is that growing businesses are often not geography dispersed. Their marketing is regional, not international, so localized disturbances more directly impact their sales.
The accessible funding line for these smaller outfits is more fragile with lower reserves and less access to loans and at higher interest rates when they can be secured. Large companies have survived their growing phase and are more stable; smaller firms are more subject to business model failures and exogenous disruptions (a new competitor or invention) with bankruptcy a higher probability.
The bottom-line is that the old investment saw of “Diversification, diversification, diversification” is operative with respect to business sizes. Smart large businesses have the resources to do it, small businesses do not.
The equity marketplace recognizes these small organization frailties in the risk-reward tradeoffs. Standard deviation is one incomplete measure of risk that is easily available for all stocks.
An example of the market’s pricing sensitivities is to compare the Vanguard S&P 500 Index (VFINX) with the Vanguard Small Cap Value Index (VISVX) funds. My comparison dates to 1998 which is the first year of operation for the Small Cap Value fund. Here is a Link to that data set:
Since VISVX inception, it has cumulatively outperformed the S&P 500 Index. From the Morningstar’s chart, VISVX has turned an initial $10K investment into $39.6K while the large cap S&P 500 produced $23.6K.
Given the wild rides of the marketplace, this ordering of outcome will not persist for all specific timeframes. One thing is certain; change will happen.
Once again historically, the marketplace belonged to Mom and Pop investors. Now, professional players dominate the landscape. Indexing was nearly nonexistent early-on. Now it is 30% of the investment funds (about half professional and half Mom and Pop). Vanguard now controls more money than does Fidelity. Sea changes are not uncommon in the investment world, so an individual investor must always be alert.
Investment opportunities quickly fade. The speed needed to take advantage of these opportunities almost always takes the individual investor out of the ballgame. Even Hedge funds suffer this fate. But some general principles remain like diversification and reversion-to-the-mean.
I hope this helps. Enough pontificating. Thanks for giving me the chance to do so.
@MJG: Very nice; thanks. The forward P/E of the Vanguard Small Cap Value fund is 16.65 For the S&P 500 Index fund, it is 17.01 In terms of predicting the relative future performance, I guess that gives the small cap value index a slight edge. Of course there are a lot of other factors besides the forward P/E ratio, not the least of which is the accuracy of those forward earnings forecasts.
For me the bigger factor is that I have been fully invested for a long time. For me to invest in small cap value, I would have to sell current holdings to make the switch, and that involves both Federal capital gains tax, and a State tax in a tax-unfriendly State.
If you do the math, it's a difficult hurdle. $100 invested today becomes much less than $100 after both Federal and State taxes on the gains are removed. Then, even if the new investment has a higher percentage return than the old, that higher percentage is applied to a lower principal amount. Selling a total market index fund in order to purchase a small cap value fund is a dicey proposition, as is selling another mutual fund to do the same.
FWIW, here the newest GMO 7 year forecast has U.S. Quality @ 2.3%, U.S. large cap @ -1.5%, and U.S. Small Cap @ -4.5% annual after inflation.
I'm also dubious of M*'s Vanguard figures because they only update by the quarter. IJS, which is updated daily lists a P/E of 18.75 vs. ITOT which has a P/E of 17.33.
FWIW, here the newest GMO 7 year forecast has U.S. Quality @ 2.3%, U.S. large cap @ -1.5%, and U.S. Small Cap @ -4.5% annual after inflation.
I'm also dubious of M*'s Vanguard figures because they only update by the quarter. IJS, which is updated daily lists a P/E of 18.75 vs. ITOT which has a P/E of 17.33.
Take with whatever grains of salt you like.
@mrdarcy or anyone else who knows: Can we get a clear, unambiguous definition of what GMO means by "U.S. Quality"? What mutual funds and exchange traded funds are there that focus on what GMO calls "U.S. Quality"? Note from above that U.S. Quality is not the same as U.S. large cap.
Also, I think GMO may be using the Shiller CAPE 10 price to earnings ratio to determine these expected 7-year returns. There are exchange traded funds and one mutual fund that specifically choose low Shiller CAPE 10 ratios. For example, Barclays ETN+ Shiller CAPE ETN CAPE ; also the exchange traded fund GVAL specifically chooses only countries that have low Shiller P/E ratios, and currently the portfolio has a P/E of 11.5 per Morningstar. Also DoubleLine Shiller Enhanced CAPE N DSENX
@rjb112 Here is a GMO "white paper" on quality. If you can't open it (I have a registration at GMO.com) try googling 'Profits for the Long Run: Affirming the Case for Quality' by Chuck Joyce and Kimball Mayer. They lean towards corporate profitability, which they claim is predictable and safe. You could probably throw in cash flow and ROE as good proxy measures.
We believe, and have to date demonstrated, that the best ex-ante indicator of low forward absolute risk is found not by studying historical market price data, but through the study of corporate profits. This harks back to the way in which Ben Graham talked of risk. He argued that real risk was “the danger of a loss of quality and earnings power through economic changes or deterioration in management.”
Following this logic would argue for a portfolio constructed of companies with high and stable profits, which should, by controlling “real risk,” result in low and stable “price risk.” Hence one needs a framework for identifying future corporate profitability.
...
Standard orthodoxy such as the positive relationship between leverage and profitability is demonstrably backwards. Contrary to modern corporate finance theory, higher returns to corporations and equity holders result from unassailable corporate moats, not from corporate leverage. This is the world as described by Warren Buffett, not Modigliani-Miller.
At the end of the day, the returns (or lack thereof) earned by stock investors are entirely a function of the underlying corporate profits of the stocks held in a portfolio. The exchanges offer no more than a pass-through of earnings to investors. In the absence of earnings, there will eventually be abysmal returns and no dividends. If there are earnings, any price volatility will ultimately net out, delivering those earnings to investors with a long-term time horizon.
This argues strongly for a risk and investing framework focused on the survivability of corporate profits under any scenario. Companies with high and stable profits do not go bankrupt. Companies with exceptional profitability generate exceptional returns. Likewise, those with low profits will fare poorly
To take this back to the SCV discussion, because it wraps up the distinctions in the positions very neatly, compare this quote with MJG's last post:
Small size often makes the company more vulnerable to unexpected perturbations. Typically their product line is more focused and not as diverse as a Large firm. Another risk factor is that growing businesses are often not geography dispersed. Their marketing is regional, not international, so localized disturbances more directly impact their sales.
The accessible funding line for these smaller outfits is more fragile with lower reserves and less access to loans and at higher interest rates when they can be secured. Large companies have survived their growing phase and are more stable; smaller firms are more subject to business model failures and exogenous disruptions (a new competitor or invention) with bankruptcy a higher probability.
See how these two theories of outperformance are saying exactly opposite things?
VISVX has outperformed VFINX since inception. But small caps haven't over longer time frames (1979-present), and especially in the period from 1984-1999. They also fell much harder in 2008. I'm agnostic to why, but there is another side to this from what the financial orthodoxy says that is very compelling.
As to "quality" funds, I would suspect that the usual suspects are in play: VIG, MOAT, USMV, SPLV, VDIGX, SEQUX, PRBLX (I own), LEXCX, and BRK.B. I think some of the smart-beta folks might be coming up with "quality" oriented small cap funds. There are some small cap OEFs that seem to try to do this as well, like VVPSX, MSCFX, and Walthausen.
Thanks for the chance to ramble in this thread. I enjoyed it. Now back to Series 7 land.
I call " bullsh@t" on the claimed forward PE of the Vanguard offering. Small caps are wildly overvalued and will likely lead the next decline. I would never advise initiating or adding to SC exposure here.
I call " bullsh@t" on the claimed forward PE of the Vanguard offering. Small caps are wildly overvalued and will likely lead the next decline. I would never advise initiating or adding to SC exposure here.
@MarkM: Let's make a distinction between small cap overall, and small cap value. When you say "Small caps are wildly overvalued", you may be referring to small cap stocks as a group, or especially small cap growth. iShares Russell 2000 IWM has a forward P/E of 19.63, versus the S&P 500 forward P/E of 17.01, per Morningstar. Vanguard S&P Small-Cap 600 Index etf VIOO has a forward P/E of 20.39. Vanguard Small Cap Growth etf VBK has a forward P/E of 25.09. Is that what you are referring to? iShares S&P Small-Cap 600 Value IJS has a forward P/E of 18.75. iShares Russell 2000 Value IWN has a P/E of 17.51. That doesn't seem "wildly overvalued" compared to the stock market overall. iShares Russell 2000 Growth IWO has a P/E of 22.54. iShares Core S&P Total US Stock Mkt ITOT P/E 17.33 The Wall Street Journal lists the forward P/E of the Russell 2000 as 19.6; the S&P 500 as 16.58; and the Dow as 15.05. @MarkM: perhaps the Dow 30 suits you better, with a P/E of 15.05. Seems like a very reasonable P/E to me, and perhaps a place to put some money, on the eft DIA
Summary:
1. The overall stock market, the total market, has a forward P/E of roughly 17.3 to 17.4 2. Small cap growth has a forward P/E of roughly 22.5 to 25 3. Small cap overall (value plus growth) has a P/E of roughly 19.6 to 20.4 4. Small cap value has a P/E of roughly 16.65 to 17.5 to 18.75, depending on the source of the information. Don't have a great consensus on that one. Would need to study this more to get a better handle on why the figures vary so much.
>> Small caps are wildly overvalued and will likely lead the next decline. I would never advise initiating or adding to SC exposure here.
I have been reading this every six months or so for the last several years. Just graphed PENNX, FSCRX, WEMMX, and GABSX 10/9/8/7/6/5/4/3/2/1y to calm myself down.
1. The overall stock market, the total market, has a forward P/E of roughly 17.3 to 17.4 2. Small cap growth has a forward P/E of roughly 22.5 to 25 3. Small cap overall (value plus growth) has a P/E of roughly 19.6 to 20.4 4. Small cap value has a P/E of roughly 16.65 to 17.5 to 18.75, depending on the source of the information. Don't have a great consensus on that one. Would need to study this more to get a better handle on why the figures vary so much.
Interesting about these P/Es. Regarding the forward P/E for the S&P 500, I'm getting 3 different results that are a bit surprising with respect to the differences:
Morningstar says the forward P/E of the S&P 500 is 17.01, as of 5/31/14 Standard & Poor's [they ought to know, right??] says it is 15.64 as of 5/30/2014 The Wall Street Journal online says that it is 16.58 as of 6/27/2014
What's up with that?!
I guess we have some significant disagreements regarding the forward earnings estimates?
That's easy... with the huge volume and wild swings lately it depends what time of the day they did the calculation. Hold on... new data coming in... that may not be correct either...
Definitions matter every bit as much as costs matter when making investment decisions.
I appreciate that you are a careful researcher, so this observation is likely to be totally unnecessary. However, when consulting any financial article, be sure to understand the precise definition of whatever statistic is being quoted.
The Price to Earnings ratio is one such statistic that has plenty of special definitions that could be misleading or misinterpreted if not properly recognized. Is the Price component based on current closing price or the monthly average? Is the Earnings component based on current level or is it a trailing 12 month average? Most importantly, are those Earnings the historical values or are they future projections?
I say most importantly because an estimate of future earnings is simply a forecast prone to error. My position on forecasts has been consistent: I am basically skeptical of most financial forecasts and generally distrust them. As you correctly inferred in your post, the likely explanation for the disparity in P/Es reported is that they were generated from the various sources that you cited.
When using the P/E ratio as part of the investment decision, it is hazardous to use future estimates. These estimates are often based on optimistic guesstimates, false assumptions, and/or behavioral biases. I believe it is a far safer approach to use the historical P/E ratio.
Nobel laureate Robert Shiller recently introduced the 10-year average of real (inflation-adjusted) earnings as the Earnings denominator. That’s his Cyclically Adjusted Price to Earnings Ratio (CAPE) formulation. That smoothing operation helps to tame the wild oscillations caused by point data anomalies. That too is a good concept.
Again historically, the current levels, like those exhibited by the S&P 500 Index, are a bit on the high side of the long-term trendline, but the trendline itself has been slowly increasing over time. Nothing is constant; the constituent makeup of the S&P 500 units slowly morphs.
As always, you alone get to interpret these data in your investment decision making.
I would caution you not to get too upset about rather small disparities in reported financial statistics. Given the dynamic nature of the marketplace, these are all subject to rapid changes anyway. As other MFOers have offered, don’t be frozen into paralysis by hyper analyses.
Comments
I've been noticing that registered investment advisors far and wide have been touting small cap value indexes more and more.
My primary index fund is the total stock market index fund. Merriman, Larry Swedroe and a ton of others tout the small cap value index.
Would love to hear the opinion of MFOers.
Dimensional Fund Advisors has a lot of influence, and they favor value; small cap; small cap value; and more recently there are a couple of additional factors they are tilting toward.
Those of you who are index fund fans, are you emphasizing small cap value?
In the linked article, Paul Merriman is recommending small cap value, not just small caps in general
Look at it this way. Graph performance since, say, spring of 1999. P/E and lower divs aside, WEMMX exactly equals performance of the mighty DFSVX --- except for notably better (smoother) dip performance in 02 and 08. Wow. It also clobbers VISVX for the same 15y period, again with half the dip or better.
The 10y graph is, ow, even more dramatic, really significant outperformance, Gabelli tripling, compared with 2.5x for the other two ... and perhaps a third of the dip in 08 with much faster recovery. One team the whole time.
You can readily concoct similar odd comparisons with other SC nongrowth funds. These three are all 4*, Merriman's love of the two cited notwithstanding.
So: in this case the vaunted SCV designation gave you considerably, consistently rougher and bumpier performance for significantly inferior outcomes compared with SCB. What does that tell us? (Hasty second example: compare 10y outperformance, smaller but with identical 08 dip, of small-blend index NAESX vs VISVX.)
Yes indeed, a Small Cap Value mutual fund is a valuable holding within a portfolio. It adds robustness to the portfolio with its diversification attribute and its incremental excess returns (something like 2%) above large cap equity holdings.
This is not a new finding. Folks have been exploiting its benefits for two decades. The original research that identified its benefits was generated in 1992 by the Fama-French University of Chicago academic team. Their model is called the Fama-French Three Factor model.
The signal paper is titled “The Cross-Section of Expected Stock Returns”. It was published in the Journal of Finance. The 3-factor model includes Bill Sharpe’s market Beta term, but was expanded to incorporate a small cap component and a low price-to-book ratio value component. It represented the first perceived shortcoming in Bill Sharpe’s CAPM model.
Here’s a Link to a reasonable summary of the Fama-French work:
http://www.forbes.com/sites/frankarmstrong/2013/05/23/fama-french-three-factor-model/
As the article stated, Fama-French is a better mouse trap (but still imperfect). That discovery shocked some nonscientists. That’s an overreaction. Models are simplifications that incorporate assumptions and constraints; consequently, they are almost never perfect. That’s especially true for disciplines like economics and finance which are strongly influenced by behavioral biases and emotions which are dynamically sensitive to a host of factors.
Paul Farrell’s 8 Lazy Portfolios have practically implemented the Fama-French research in their Index heavy portfolios. Just scan these 8 portfolios, all assembled by acknowledged financial wizards, to judge its near universal acceptance. Here is the Link to Farrell’s frequently referenced scorecard:
http://www.marketwatch.com/lazyportfolio
I have been using the Fama-French work for two decades using a mix of both actively managed and passive Index mutual fund products. The obvious Index choices are Vanguard entries: Vanguard Total Stock Market Index Fund (VTSMX) and Vanguard Small-Cap Value Index Fund (VISVX).
The total stock market fund includes a fair share of small cap components, but adding the focused small cap value holding adds weight to keep portfolio returns high while slightly reducing its overall standard deviation.
The longer term (since 2000) correlation coefficient between the two Vanguard indices is 0.93; a shorter term (dating from 2012) correlation coefficient is 0.95. This minor correlation coefficient disparity between these two funds doesn’t significantly impact portfolio standard deviation, but the historical excess returns is worth pursuing.
By the way, Fama and French are currently pushing an improved 5-factor model. And so research continues……. So you have assigned yourself a never ending task. Good luck and good hunting.
Best Regards.
VBR is the ETF equivalent of VISVX. Vanguard has a significant lower E.R. for VBR.
@prinx: thanks. That Vanguard's modus operandi. They often have an investor share class, with a $3,000 minimum, and relatively higher expenses; an Admiral share class with a higher minimum and much lower expenses; and an exchange traded fund version with the same very low expenses as the Admiral shares version and of course no minimum. The Vanguard Small Cap Value Admiral and etf version have an amazing expense ratio of just 9 basis points, .09%. The Admiral shares have a $10,000 minimum purchase to get in.
One thing I don't care for in the Vanguard Small Cap Value: the stocks are too large.
The average market cap of the stocks: 2,798 million
I much prefer the DFA US Small Cap Value I DFSVX average market cap of 1,294 million
Much smaller stocks, much preferred imo for this specific purpose.
Unfortunately I have no access to DFA funds without paying for a registered investment advisor, which I have no need for at all, other than to get me into the DFA funds!
First, a graphic example. (edit: Sigh, looks like M* won't allow you to link to the period I had originally input. To look at that chart, use 6/25/1979 as the start date. The values I listed are correct.)
Those are the returns of a $10,000.00 investment in each of VFINX ($474,278.66), NAESX ($434,025.38), SCV ($524,319.28), and LCV ($411,828.31) over the past 35 years, approximately the time horizon of a retirement portfolio.
Second, the CAPM model assumes the most efficient portfolio is one that contains all the securities in a market, and that any excess return comes from increased risk. Fama-French expands that by explaining where you find that risk (beta). You aren't increasing your diversification by adding SCV to a portfolio of domestic stocks (if you doubt this, check a correlation table between VFINX and VISVX). You are adding risk in hope of greater returns.
So two questions:
1) Where are the excess returns for the small cap and value premia; and
2) if this investor didn't get greater returns, why did he/she accept greater risk?
As a lot of us probably know this, I'll just link these articles and let people ruminate on their own.
Sam Lee from M* explains Fama-French factors well here and here. He also explains his problems with Efficient Market Theory here. You can find the original paper describing the small-cap premium by Rolf Banz here.
Turns out, however, that there has been no return premium for small cap stocks since the data was gathered by Banz in 1979. How can that be? Explanations for problems with the Fama-French assumptions, start with their own recent paper explaining how the three factors are actually five. Ask yourself after, "where does this stop?"
From there you can read:
Sam lee on the Five-Factor model. ("I think this should be a come-to-Jesus moment for those who've taken the F-F model as the gospel truth. Fama and French admit that their original three-factor model was not motivated by theory. They chose value and size because they worked better than other characteristics in back-tests. Grounded in the efficient-market hypothesis, they came up with risk-based stories for these patterns. Small-cap stocks provided excess returns because they're more vulnerable to the business cycle. Value stocks did so because they were distressed.
However, since then, the size factor is no longer considered a significant source of excess returns by many academics and practitioners. Rolf Banz's original 1981 study showing a huge size premium was marred by survivorship bias. After it was corrected in the mid-1990s, back-tests showed a much smaller premium. Moreover, whatever excess returns small-cap stocks provided were driven by the smallest, least liquid securities.")
John Rekenthaler on problems with supposed historical premia. ("To the extent that smaller companies do outperform, those gains likely owe to a liquidity premium. Smaller-company shares have lower trading volume, which increases the chance of moving the stock price by putting in a trade order, and which hampers the investor’s ability to rapidly enter or exit a position. Low liquidity is a real cost that deserves to be compensated with a real return. This is fine--but properly speaking, it’s not a small-company effect.")
Finally these are articles from Advisor Perspectives, a commentary/newsletter service for FAs: 'The Small Cap Falsehood' ("The supposed outperformance of small cap stocks is a foundational precept on which many respected asset managers have staked their expertise over the years – foremost among them, Dimensional Fund Advisors (DFA), the famed fund company that has gained a near-religious following since they popularized small cap indexing three decades ago. A growing body of research, however, shows no such advantage for the last 30 years and, now, a new study seems to have proven that the supposed small-cap advantage may have never existed in the first place.");
and 'A Test for Small Cap and Value Stocks' ("In a recent talk, Stanford professor and Nobel economist Bill Sharpe challenged advocates of smart-beta strategies, including overweighting small-cap and value stocks, to respond to two questions. Can the strategy be adopted by all market participants, or does it have a practical limit in terms of assets that can be invested? If it has a practical limit, then one should expect the premium to decrease over time.
For small-cap stocks, for example, it is obvious that the answer is "no" – eventually the dollars pursuing those stocks would make them mid- or large-cap stocks. The same is true for value stocks; the money pursuing them will eventually drive prices up and erase their risk premium.
In an email exchange, [Larry] Swedroe essentially agreed.")
It should be pointed out that Merriman has an agenda here: he sells DFA funds that are uniquely based on the Fama-French factors. To be fair, those funds have done very well since inception. It is worth asking, however, if the small cap premium is based in liquidity and not size, whether an index is the best method of including this asset class in a portfolio.
It should also be said that the one factor that is predictive of future performance is valuation as measured by Shiller CAPE. And right now, US small caps have historically high valuations.
So should someone include SCV? That depends on what their horizon and goals are. But if they do weight to SCV, they should be aware they are accepting increased risk with no guarantee of increased returns.
Does anyone remember about 20 years ago when the Dogs of the Dow investing strategy became very popular? Books and articles came out showing that if you just invested in the 10 highest dividend yielding stocks of the Dow 30 on the first day of the year, held them one year, then rebalanced into the new 10 Dow "Dogs", and repeated this process every year, you would have beaten the indexes soundly.
The major full service brokerages all came out with Unit Investment Trusts that held the 10 Dow Dogs and rebalanced into the new 10 Dow dogs the first day of each year. Mutual funds came out that focused on the strategy of the Dow dogs and modified the strategy. New versions came out, such as just investing in the top 5 dividend yielding Dow stocks. Then the strategy was applied to other indexes besides the Dow, foreign indexes, etc.....
Is small cap value investing going to become the new Dogs of the Dow? Will it crescendo in popularity until everyone knows about the supposed superiority of investing in small cap value?
And as it gets pushed by more and more registered investment advisors and market 'experts', how long will it take before the outperformance weakens? Will it one day turn into underperformance?
I've got no horse in this race. Just a student of the markets, trying to learn more and more.
Wrt "keep in mind that successful SCV funds pretty quickly become categorized as MCV funds." This can certainly happen, especially if a fund, by virtue of its success, has a large increase in asset base, making it difficult for the fund to stay in the small cap space. My guess is this may have happened with Fidelity Low-Priced Stock FLPSX, which is now a midcap fund, although I don't have data from when the fund started out.
I think one can probably rest assured that a SCV index fund will stay true to its SCV space.
One SCV fund that caught my attention is Bridgeway Small-Cap Value BRSVX, which has an average market cap of 1,149 million and has been around since 2003. Interesting that the P/E ratio is only 15, and low P/B, showing its value nature. Bridgeway has some interesting funds. They also have a fund, Bridgeway Blue Chip 35 Index BRLIX, with a 174 billion dollar average market capitalization!
They have another even more interesting SCV fund, Bridgeway Omni Small-Cap Value N BOSVX, with an average market cap of only 662 million, and a P/E of 14. I'd be most interested in that one, but it looks like it is only open to financial advisors and their clients.
@bee, appreciate if you can look at your PM
I do love theoretical argument, especially by academics, but hey, I have an idea instead:
Go to M* 10k growth and chart VFINX, GABEX, GABSX, and WEMMX for 5-6-7-8-9-10y, and then max to 1998.
Report what you see then and tell how it fits in with all these theories. (I chose the last three cuz it's the same guy and team, of course.)
And/or someone could just do the charting of my earlier post above.
And of course there's no 'guarantee'.
@MJG: thanks for the excellent resources you provided.
Let me contribute a resource that I just uncovered.
I've been wanting to know what John Bogle thinks of this whole thing.
And it doesn't hurt to know what Professor Burton Malkiel thinks of it as well.
Luckily, they joined in and co-authored an op ed piece on the subject that I just read a few minutes ago, and it's well worth reading for anyone interested in this subject:
http://johncbogle.com/wordpress/wp-content/uploads/2006/08/WSJ op-ed.pdf
Comparing the 10-15 year returns of certain active funds with that of the S&P is a bit apples to oranges. I'm with you that active management provides downside protection and the possibility of better returns. But the question was "does SCV provide better returns?"
Over the last 15 years, the answer has been yes. But look back to valuation levels in 1999. The nature of market-cap weighting meant the S&P was full of overvalued tech stocks waiting to crash, while small value stocks languished. Savvy, patient managers were able to provide great returns when that bubble broke. But those conditions do not exist today. As an example, look at the returns of $10,000.00 for VFINX ($136,691.30 or 19.05%) vs. NAESX ($48,688.57 or 11.13%) over the previous 15 years, 6/26/1984 - 6/26/1999. Incidentally, the Tech and Japan Bubbles are my arguments #1 and #2 against market-cap indices.
That's why I gave 35 year returns of four distinct equity areas. 1979 was chosen for three reasons: First, 35 years is a long enough time to start to be statistically significant; second, 35 years is a fair approximation of the horizon of a retirement savings plan; Third, the evidence that small-cap stocks outperform was taken from the Rolf Banz 1979 paper using data from 1936-1975.
Over the past 35 years, the returns were:
VFINX = 11.66%
NAESX = 11.37%
M*'s LCV tracker = 11.21%
M*'s SCV tracker - 11.98%
Banz's paper was subject to later revision when people realized he hadn't accounted for survivorship bias. But that didn't stop Fama and French from harping on about the size premium, and how you get compensated for increased risk. And now they've gone back and admitted they just kind of made that up, but, hey, here's a whole new model!
Like I said, I'm skeptical of indexing in this space. If the small cap premium is actually just a liquidity premium, then what one should be looking for is actually microcaps, which I suspect actually do behave rather differently than larger equities and might help diversify. But that same lack of liquidity makes it awfully hard to index.
BRSIX is a sort of microcap index that seems to do well and that I've considered. For now, though, I just let the nice folks at Grandeur Peak handle this for me. Growthier, sure, but you can't beat the exposure to globally local microcaps. Perhaps their eventual fallen angels fund?
'start to be' --- now there's a stats assertion you don't read every day.
Speaking of timespans, GPGOX and BRSIX do look interesting, and outperform WEMMX recently (only recently).
Apologies if I misinferred.
This is not a rhetorical question.
It is very easy to invest in a small cap value index. It takes no skill, knowledge or abilities. Supposedly that has produced significant out-sized returns in the past. Is there any reason to believe this pattern will continue into the future, since it is now well known?
Is there a free lunch out there in investing?
Appreciate your comments.
What works on Wall Street is not constant. That’s why the super quants who currently run the most successful Hedge funds are so secretive about their methods and must use the highest speed computers to find and to exploit the market inefficiencies.
Folks have been learning this investment lesson forever. Jesse Livermore never revealed his secrets and continuously revised them based on present conditions.
In 1996, James O’Shaughnessy wrote a book titled “What Works on Wall Street” after much research. It was celebrated as the most influential investment book over decades. When O’Shaughnessy initiated a mutual fund to put his findings into practice, it failed miserably. He sold the fund, and the methods he discovered generated excess returns for a period thereafter. Investment strategies come and go and often return. These things are highly transient.
Risk and reward are tied at the hip, but with a bungee cord so that departures in time and space are variable and unpredictable. But the cord does exist. It is captured in the Wall Street rule of a regression-to-the-mean.
Each investor gets to choose his own risk level. As Ben Franklin said: “He that would catch fish, must venture his bait”. More recently, Nassim Taleb observed: “Risk taking is necessary for large success – but it is also necessary for failure”. You get to pick where on the risk spectrum your portfolio is positioned.
There are no free lunches. The marketplace is not a perfect measuring machine and is never in equilibrium. Markets move in that ideal direction, but never quite get there. Some exogenous event disrupts the process. Physically, it’s like an agitated coiled spring that is slowing down to an equilibrium, but gets an unexpected push. Opportunities present themselves but are extremely transient. Hard work is the price to identifying opportunities.
Two themes that run throughout Scott Patterson’s excellent book “The Quants” are the secret, competitive nature of its participants, and the need for hypersonic speed. The market pricing dislocations don’t persist. For these wiz-kids, The Truth is an elusive target. Emotions are high and disaster is always near, especially when excessive leverage is deployed to magnify small percentage profits into outsized wealth.
Many long-term players say investing is conceptually easy, but difficult to execute. When David Swensen was writing “Unconventional Success”, he changed the entire format of his book to advocate an Index approach when he realized that the average investor had neither the time, knowledge, or resources needed to execute the strategies deployed by successful professionals.
In the business world size does matter.
A reasonable analogy is the human lifecycle. A vibrant adult (a mature business) is better equipped to endure and survive “the slings and arrows of outrageous (mis)fortune” than a baby (an upstart business).
Again, historically investment asset classes do have a pecking order in terms of expected returns with anticipated risk factors. Typically, but not always since the marketplace can be wild and illogical for excruciatingly long periods, Small Cap rewards are expected to outdistance Large Cap returns. The historical data generally supports this proposition.
Although Small Caps are often expected to deliver about 2 % incremental returns over their Large Cap brethren, current investor perceptions that are both factually and emotionally driven do distort these projections. Why?
Small size often makes the company more vulnerable to unexpected perturbations. Typically their product line is more focused and not as diverse as a Large firm. Another risk factor is that growing businesses are often not geography dispersed. Their marketing is regional, not international, so localized disturbances more directly impact their sales.
The accessible funding line for these smaller outfits is more fragile with lower reserves and less access to loans and at higher interest rates when they can be secured. Large companies have survived their growing phase and are more stable; smaller firms are more subject to business model failures and exogenous disruptions (a new competitor or invention) with bankruptcy a higher probability.
The bottom-line is that the old investment saw of “Diversification, diversification, diversification” is operative with respect to business sizes. Smart large businesses have the resources to do it, small businesses do not.
The equity marketplace recognizes these small organization frailties in the risk-reward tradeoffs. Standard deviation is one incomplete measure of risk that is easily available for all stocks.
An example of the market’s pricing sensitivities is to compare the Vanguard S&P 500 Index (VFINX) with the Vanguard Small Cap Value Index (VISVX) funds. My comparison dates to 1998 which is the first year of operation for the Small Cap Value fund. Here is a Link to that data set:
http://quotes.morningstar.com/fund/visvx/f?rbtnTicker=Ticker&t=VISVX&x=0&y=0&SC=Q&pageno=0&TLC=
Since VISVX inception, it has cumulatively outperformed the S&P 500 Index. From the Morningstar’s chart, VISVX has turned an initial $10K investment into $39.6K while the large cap S&P 500 produced $23.6K.
Given the wild rides of the marketplace, this ordering of outcome will not persist for all specific timeframes. One thing is certain; change will happen.
Once again historically, the marketplace belonged to Mom and Pop investors. Now, professional players dominate the landscape. Indexing was nearly nonexistent early-on. Now it is 30% of the investment funds (about half professional and half Mom and Pop). Vanguard now controls more money than does Fidelity. Sea changes are not uncommon in the investment world, so an individual investor must always be alert.
Investment opportunities quickly fade. The speed needed to take advantage of these opportunities almost always takes the individual investor out of the ballgame. Even Hedge funds suffer this fate. But some general principles remain like diversification and reversion-to-the-mean.
I hope this helps. Enough pontificating. Thanks for giving me the chance to do so.
Best Wishes.
The forward P/E of the Vanguard Small Cap Value fund is 16.65
For the S&P 500 Index fund, it is 17.01
In terms of predicting the relative future performance, I guess that gives the small cap value index a slight edge. Of course there are a lot of other factors besides the forward P/E ratio, not the least of which is the accuracy of those forward earnings forecasts.
For me the bigger factor is that I have been fully invested for a long time. For me to invest in small cap value, I would have to sell current holdings to make the switch, and that involves both Federal capital gains tax, and a State tax in a tax-unfriendly State.
If you do the math, it's a difficult hurdle. $100 invested today becomes much less than $100 after both Federal and State taxes on the gains are removed. Then, even if the new investment has a higher percentage return than the old, that higher percentage is applied to a lower principal amount. Selling a total market index fund in order to purchase a small cap value fund is a dicey proposition, as is selling another mutual fund to do the same.
I'm also dubious of M*'s Vanguard figures because they only update by the quarter. IJS, which is updated daily lists a P/E of 18.75 vs. ITOT which has a P/E of 17.33.
Take with whatever grains of salt you like.
http://www.bogleheads.org/forum/viewtopic.php?f=10&t=141809&newpost=2105689
Mona
Also, I think GMO may be using the Shiller CAPE 10 price to earnings ratio to determine these expected 7-year returns. There are exchange traded funds and one mutual fund that specifically choose low Shiller CAPE 10 ratios. For example, Barclays ETN+ Shiller CAPE ETN CAPE ; also the exchange traded fund GVAL specifically chooses only countries that have low Shiller P/E ratios, and currently the portfolio has a P/E of 11.5 per Morningstar. Also DoubleLine Shiller Enhanced CAPE N DSENX
VISVX has outperformed VFINX since inception. But small caps haven't over longer time frames (1979-present), and especially in the period from 1984-1999. They also fell much harder in 2008. I'm agnostic to why, but there is another side to this from what the financial orthodoxy says that is very compelling.
As to "quality" funds, I would suspect that the usual suspects are in play: VIG, MOAT, USMV, SPLV, VDIGX, SEQUX, PRBLX (I own), LEXCX, and BRK.B. I think some of the smart-beta folks might be coming up with "quality" oriented small cap funds. There are some small cap OEFs that seem to try to do this as well, like VVPSX, MSCFX, and Walthausen.
Thanks for the chance to ramble in this thread. I enjoyed it. Now back to Series 7 land.
When you say "Small caps are wildly overvalued", you may be referring to small cap stocks as a group, or especially small cap growth. iShares Russell 2000 IWM has a forward P/E of 19.63, versus the S&P 500 forward P/E of 17.01, per Morningstar. Vanguard S&P Small-Cap 600 Index etf VIOO has a forward P/E of 20.39. Vanguard Small Cap Growth etf VBK has a forward P/E of 25.09. Is that what you are referring to? iShares S&P Small-Cap 600 Value IJS has a forward P/E of 18.75.
iShares Russell 2000 Value IWN has a P/E of 17.51. That doesn't seem "wildly overvalued" compared to the stock market overall. iShares Russell 2000 Growth IWO has a P/E of 22.54. iShares Core S&P Total US Stock Mkt ITOT P/E 17.33
The Wall Street Journal lists the forward P/E of the Russell 2000 as 19.6; the S&P 500 as 16.58; and the Dow as 15.05. @MarkM: perhaps the Dow 30 suits you better, with a P/E of 15.05. Seems like a very reasonable P/E to me, and perhaps a place to put some money, on the eft DIA
Summary:
1. The overall stock market, the total market, has a forward P/E of roughly 17.3 to 17.4
2. Small cap growth has a forward P/E of roughly 22.5 to 25
3. Small cap overall (value plus growth) has a P/E of roughly 19.6 to 20.4
4. Small cap value has a P/E of roughly 16.65 to 17.5 to 18.75, depending on the source of the information. Don't have a great consensus on that one. Would need to study this more to get a better handle on why the figures vary so much.
I have been reading this every six months or so for the last several years. Just graphed PENNX, FSCRX, WEMMX, and GABSX 10/9/8/7/6/5/4/3/2/1y to calm myself down.
Definitions matter every bit as much as costs matter when making investment decisions.
I appreciate that you are a careful researcher, so this observation is likely to be totally unnecessary. However, when consulting any financial article, be sure to understand the precise definition of whatever statistic is being quoted.
The Price to Earnings ratio is one such statistic that has plenty of special definitions that could be misleading or misinterpreted if not properly recognized. Is the Price component based on current closing price or the monthly average? Is the Earnings component based on current level or is it a trailing 12 month average? Most importantly, are those Earnings the historical values or are they future projections?
I say most importantly because an estimate of future earnings is simply a forecast prone to error. My position on forecasts has been consistent: I am basically skeptical of most financial forecasts and generally distrust them. As you correctly inferred in your post, the likely explanation for the disparity in P/Es reported is that they were generated from the various sources that you cited.
When using the P/E ratio as part of the investment decision, it is hazardous to use future estimates. These estimates are often based on optimistic guesstimates, false assumptions, and/or behavioral biases. I believe it is a far safer approach to use the historical P/E ratio.
Nobel laureate Robert Shiller recently introduced the 10-year average of real (inflation-adjusted) earnings as the Earnings denominator. That’s his Cyclically Adjusted Price to Earnings Ratio (CAPE) formulation. That smoothing operation helps to tame the wild oscillations caused by point data anomalies. That too is a good concept.
Again historically, the current levels, like those exhibited by the S&P 500 Index, are a bit on the high side of the long-term trendline, but the trendline itself has been slowly increasing over time. Nothing is constant; the constituent makeup of the S&P 500 units slowly morphs.
As always, you alone get to interpret these data in your investment decision making.
I would caution you not to get too upset about rather small disparities in reported financial statistics. Given the dynamic nature of the marketplace, these are all subject to rapid changes anyway. As other MFOers have offered, don’t be frozen into paralysis by hyper analyses.
Good luck and Best Wishes.