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Market focus: How smart is smart beta?

Professional Investors are familial with the Fama-French Factor model developed by Nobel Prize Laureate Eugene Fama with his colleague Kenneth French in the 1990s. According to this model, the expected return on a stock is the combination of the general equity market premium – the so-called beta of the single risk factor model – to which they added a “size premium” – on the premise that small cap stocks are expected to generate higher returns than large caps – and the value premium which is a reflection of a stock’s lower valuation compared to other stocks which trade higher on the basis of their expected earnings. This academic theory is at the heart of the so-called “smart beta” strategy based on ETFs – Exchange Traded Funds – which seek to replicate an exposure to the risk factors identified by Fama-French and by other pundits. However, since the beginning of the year, here have been a puzzling disconnect between “Growth stocks” and “Value stocks”.

US Equities performance by factor

Professional Investors are familial with the Fama-French Factor model developed by Nobel Prize Laureate Eugene Fama with his colleague Kenneth French in the 1990s. According to this model, the expected return on a stock is the combination of the general equity market premium – the so-called beta of the single risk factor model – to which they added a “size premium” – on the premise that small cap stocks are expected to generate higher returns than large caps – and the value premium which is a reflection of a stock’s lower valuation compared to other stocks which trade higher on the basis of their expected earnings. This academic theory is at the heart of the so-called “smart beta” strategy based on ETFs – Exchange Traded Funds – which seek to replicate an exposure to the risk factors identified by Fama-French and by other pundits.

However, since the beginning of the year, as the chart above shows there have been a puzzling disconnect between  “growth stocks” or “momentum stocks” on one hand – and both “value stocks” and small cap stocks on the other hand, whatever the methodology for selecting those stocks. This divergence in favour of growth stocks seems to run counter Fama-French’s model or counter common intuition that in order to make money one has to buy what is cheap and to sell what is expensive. Warren Buffett may have been practicing “smart beta” for years without even knowing it. The terrible performance of his flagship investment vehicle, Berkshire Hathaway; which has fallen of a cliff when the market crashed in February and remains stuck deep in the red, is yet another testimony to the ongoing dislocation. 

The growing divergence between different factor-based or “style” indices since the beginning of the year is striking.

Over the last few weeks, the US stock market has been lifted thanks to the Large Cap / Growth stocks while the Value / Small Cap stocks have stalled.

Over the 2001-2020 period

Looking on a longer horizon the picture looks quite different with small caps benefiting from a significant premium over other stocks, proving right Fama-French multi-factor theory at least regarding the importance of the size factor. In contrast the performance of value stocks has been disappointing. Smart Beta seem to perform well over an extended period of time. Same could be said looking at the performance of Warren Buffet’s Berkshire Hathaway over twenty years as opposed to just the last couple of months or years.

From 01/01/2020 to 13/07/2020 the value of the S&P 500 index fund yielded 3.55 its initial investment, while the the high dividend index yielded 2.4, the momentum fund yielded 2.95, close to the value fund (3.02). The best performer was the small cap fund which yielded 3.91 or almost four times the money invested in it. We can also see how the different “style” based funds performed during the mild 2001 recession and the severe 2007-2008 recession.

The relative return of the different “style” funds compared to the SPDR S&P 500 index fund help us better to understand the time periods which contributed the most to the spreads between the cumulated absolute returns over the whole period. We can see from the chart that most of the divergence between the Small caps index fund and the S&P index fund occurred between 2001 and 2007. Starting from 2007 the over-performance of the Small Caps index fund started to decline. The over-performance gap was gradually closed over the 2007-2020 period but the early gains were factored in. It also striking to see that the low volatility index fund outperforms the S&P index fund by a large margin during the recessions and in the immediate recovery periods and starts to lose its steam once the expansion becomes more robust.

Over the 2010 – 2020 period

Let us look over the last ten years to see how the different style investment themes have played out. We can see that over the last ten years, large cap growth stocks actually outperformed significantly their value and small cap counterparts. This runs counter the Fama-French theory. Even taking into account that this theory is supposed to hold better over the long term, this means the market can experience prolonged deviations from what the model tells us.

ETFs used for this analysis.

StyleTickerIssuerUnderlying index
IndexSPYSPDR (S&P)S&P 500 Index
GrowthSPYGSPDR (S&P)S&P 500 Growth Index
ValueSPYVSPDR (S&P)S&P 500 Value Index
High DividendVYMVanguardFTSE High Dividend Yield Index
MomentumMTUMiShares (Blackrock)MSCI USA Momentum Index
Small CapIWMiShares (Blackrock)Russell 2000 Index
Low VolatilityUSMViShares (Blackrock)MSCI USA Minimum Volatility (USD) Index.

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