Professional Financial

April, 2024

Most investors commonly believe that the familiar S&P 500 index comprises the largest 500 US stocks by market capitalization. That’s not true. In fact, Standard & Poors has a long list of eligibility requirements developed for its committee’s use that automatically excludes many big U.S. companies not meeting their particular criteria. As of last February, 73 companies ranking among the largest 500 in the U.S. by market capitalization that were included in competitors’ market cap-weighted indexes were excluded from the S&P 500 index. The combined group represents $2.1 trillion in market value. That is 25% more than Australia’s entire stock market valuation.¹

For example, to be included in the S&P index, companies must have positive earnings over the past four quarters. Further S&P index weighting does not necessarily correspond to market weight — usually due to anticipated trading issues, particularly for less traded stocks. Accordingly, many index lists created by S&P and others frequently use stock representations of market exposure for fund managers. Therefore, as with our S&P example, a firm’s index rules may cloud investors’ understanding of what their portfolio holds and thus the expected return to anticipate.²

Exhibit 1: Largest U.S. Companies Excluded from S&P 500 Index

Comparison of US-listed securities by market cap as of February 29, 2024

Source: Dimensional Fund Advisors using data from Russell, S&P, and MSCI.
Companies not in the S&P 500 Index are in the top 500 stocks by market capitalization in the Russell 3000 Index as of February 29, 2024, but absent from the S&P 500 Index. The Russell 3000 index is market cap weighted.
Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. © 2024 S&P Dow Jones Indices LLC, a division of S&P Global. MSCI data © MSCI 2024.
Indices are not available for direct investment. This information is intended for educational purposes and should not be considered a recommendation to buy or sell a particular security.

Do Small Cap Indexes Only Have “Small” Stocks?

Small cap stock indexes funds all have a serious index inconsistency. For instance, the name of the Russell 2000 Index might make you believe it holds stocks only smaller than the 1,000th largest US stock by market cap weighting. That is true only at the beginning of each annual reconstitution.

Russell’s index construction protocols cater to fund managers dealing with tracking an index of costly-to-trade small stocks — a cost compounded if it must be done too often. Other index providers buy or sell the very same stocks, all traded at the same times. Similar to the S&P 500, Russell actively incorporates methodological simplifications, such as bands minimizing turnover near market capitalization breakpoints and multi-week lags between the security rank date and reconstitution date. Again, the market is represented, but not replicated. We note those adjustment reduced the Russell 2000’s turnover from 29.8% on average, from 1996–2005, to 11.8% since 2006.

While Russell modifications reduce the negative market impact of selling or buying small stocks too often as they approximate the small market index, they come at the expense of reduced expected returns due to style drift as stocks grow in size. Funds licensing the Russell 2000 Index, for example, on average had more than 20% of its constituent weight within the largest 1,000 stocks. Implementing a small stock strategy whose portfolio protocols are guided by prioritizing dimensional drivers of returns from financial science, rather than simply conform to arbitrary tracking targets, better position portfolios to realize the enhanced expectations of small stock returns.

Exhibit 2: Bending Index Rules

Weighting over time of the larger 1,000 stocks in the Russell 2000 Index, December 2009 to August 2023

Source: Source: Dimensional Fund Advisors using data from Russell. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes.

Trusting the Market for Returns, Not Tracking

Conventional indexing tracks the market (at least to a certain extent) to keep costs lower. The problem is that hedge funds know that index providers tell index managers what to hold and when to trade and ruthlessly exploit an opportunity. Consequently, the limited flexibility of index rebalancing leads to degraded outcomes. Long periods between index reconstitutions to minimize opportunistic trading causes considerable style drift — too many small stocks moving out of index alignment, creating more opportunity costs from degraded expected returns due to reduction of size exposure.

Dimensional Fund Advisors, employing a management process refined over decades, systematically focuses on portfolio segments, and flexibly chooses from a group of similar securities with higher return characteristics. Drawing insights from financial science, information derived from prices screens securities in real time with higher expected returns. Further value through incremental daily trading without unreliable guesswork of active management, allows for implementation opportunities.

FOOTNOTES

1. Australian stocks in the MSCI All Country World IMI index. MSCI data @MSCI 2024

2. How many readers actually study stock index fund prospectus and compare market-weighted lists?

March, 2024

The 20-year return of US small cap value stocks versus the S&P 500 Index of large US stocks negatively dipped this year for the first time in US stock market history. Two decades is a long time to wait for a planned expected premium not to show up.

Prudently, our portfolio strategies have multiple asset classes, so fair market returns have been captured in other asset classes. Still, negative outliers in a portfolio’s dimensional allocation are not outcomes we want. But examining returns following similar past outlier periods encourages us to believe better returns may be coming.

Older practitioners still recall the disappointing stretch that ended in 2000 when U.S. small cap value’s trailing 20-year return was statistically indistinguishable from the S&P 500 return. Much less familiar are two 20-year periods, one ending in 1947 and the other in 1965 when the trailing 20-year premium was similarly flat.

In all three cases, a sudden turnaround of the small value equity premium surprised investors. The return impact of what happened can be seen by measuring the trailing 20-year return spreads just three years later. For example, the observation on December 31, 1999 can be compared with the trailing 20-year return difference as of December 31, 2002. In each case absent performance was made up as small cap value’s annualized premium surged more than three percentage points per year.

Exhibit 1: Expecting Better Returns?

Difference of Dimensional US Small Cap Index and US S&P 500 Market Index, 20-year rolling return May 1947–January 2024

Source: Dimensional Fund Advisors LP. Past performance is no guarantee of future results. Actual returns may be lower. The Dimensional indices represent academic concepts that may be used in portfolio construction and are not available for direct investment or for use as a benchmark. Index returns are not representative of actual portfolios and do not reflect costs and fees associated with an actual investment. See “Index Descriptions” for descriptions of the Dimensional index data. S&P data © 2024 S&P Dow Jones Indices LLC, a division of S&P Global.

A sudden turnaround is unpredictable. But historical data implies that quitting small cap value allocations after suffering a lengthy poor return stretch while invested would have been a costly mistake. Past poor performance of any premium for extended periods doesn’t upend the economic logic of expecting a higher return for stocks with low prices relative to their book equity, and lower returns for those with high relative prices.

For any questioning our academic research for planning, we note that a corresponding underperformance has not occurred in developed ex US or emerging markets: small cap value stocks as a group have outperformed their large cap counterparts by 2.7%¹ and 4.0%², respectively, over the recent past 20 years.

Professional Financial has a number of clients with us from the difficult years following 1999. As the market cycle recovered from the so-called “Tech Bust,” only to be followed by a highly stressful Global Financial Crisis, those clients pleasantly recollect how the value dimension of their diversified structured portfolios performed:

• The cumulative return of the US small cap value index versus the S&P 500 index was 194.1% versus -8.8% over 5 years, and 204.1% versus -5.6% over 10 years.

Looking further back to a largely unfamiliar period in the 1960s back when computers first were used for account reporting and when historical market returns were first calculated, from the value premium low point in June of 1965:

• The cumulative return of a US small cap value index (were it available to investors) versus what would become the today’s S&P 500 index was 60.3% versus only 2.1% over five years, and 128.7% versus only 45.2% over 10 years.

Past performance, of course, is no assurance of future results and timing is unreliable. But informed dimensional planning relies on a cost of capital story: expected return and risk are related. Valuation theory holds that prices operate broadly within a competitive environment which compensates return tradeoffs. Thus, while you will be disappointed at times, an extended period of rewarding financial outcomes for those committed to their small value strategy allocations should not surprise us.

FOOTNOTES

1. Based on the Dimensional International Small Cap Value Index (net div., USD) versus the MSCI World ex USA Index (net div., USD) over the 20 years ending 1/31/2024. MSCI data © MSCI 2024.

2. Based on the Dimensional Emerging Markets Small Value Index (net div., USD) versus the MSCI Emerging Markets Index (net div., USD) over the 20 years ending 1/31/2024. MSCI data © MSCI 2024.

Glossary

Expected premium: Represents the expected return difference between two investments. An expected return is the percentage increase in value a person may anticipate from an investment based on the level of risk associated with the investment, calculated as the mean value of the probability distribution of possible returns.

Index Descriptions

The Dimensional indices have been retrospectively calculated by Dimensional Fund Advisors LP and did not exist prior to their index inception dates. Accordingly, results shown during the periods prior to each index’s index inception date do not represent actual returns of the index. Other periods selected may have different results, including losses. Backtested index performance is hypothetical and is provided for informational purposes only to indicate historical performance had the index been calculated over the relevant time periods. Backtested performance results assume the reinvestment of dividends and capital gains.

Dimensional US Small Cap Value Index was created by Dimensional in March 2007 and is compiled by Dimensional. It represents a market-capitalization-weighted index of securities of the smallest US companies whose market capitalization falls in the lowest 8% of the total market capitalization and whose relative price is in the bottom 35% of the eligible market, or 25% prior to January 1975, after the exclusion of utilities, companies lacking financial data, and companies with negative relative price. The eligible market is composed of securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market. Exclusions: non-US companies, REITs, UITs, and investment companies. From January 1975 to the present, the index excludes companies with the lowest profitability and highest relative price within the small cap universe. The index also excludes those companies with the highest asset growth within the small cap universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Asset growth is defined as change in total assets from the prior fiscal year to the current fiscal year. Source: CRSP and Compustat. The index monthly returns are computed as the simple average of the monthly returns of 12 subindices, each one reconstituted once a year at the end of a different month of the year. The calculation methodology was amended in January 2014 to include profitability as a factor in selecting securities for inclusion in the index. The calculation methodology was amended in December 2019 to include asset growth as a factor in selecting securities for inclusion in the index.

Dimensional International Small Cap Value Index was created by Dimensional in April 2008 and is compiled by Dimensional. January 1990–present: Consists of small cap companies in eligible markets whose relative price is in the bottom 35% of their country’s respective constituents, after the exclusion of utilities and companies with either negative or missing relative price data. The index excludes securities with the lowest profitability within their country’s small cap universe. The index also excludes those companies with the highest asset growth within their country’s small cap universe. Profitability is defined as operating income before depreciation and amortization minus interest expense divided by book equity. Asset growth is defined as change in total assets from the prior fiscal year to the current fiscal year. The index monthly returns are computed as the simple average of the monthly returns of four sub-indices, each one reconstituted once a year at the end of each quarter of the year. Exclusions: REITs and Investment Companies. July 1981–December 1989: Includes securities, of MSCI EAFE countries, in the top 30% of book-to-market by market capitalization conditional on the securities being in the bottom 10% of market capitalization, excluding the bottom 1%. All securities are market capitalization weighted. Each country is capped at 50%. Rebalanced semiannually. Source: Bloomberg. The calculation methodology was amended in January 2014 to include profitability as a factor in selecting securities for inclusion in the index. The calculation methodology was amended in November 2019 to include asset growth as a factor in selecting securities for inclusion in the index.

Dimensional Emerging Markets Small Value Index was created by Dimensional in April 2008 and is compiled by Dimensional. Consists of small cap companies in eligible markets whose relative price is in the bottom 35% of their country’s respective constituents, after the exclusion of utilities and companies with either negative or missing relative price data. The index excludes securities with the lowest profitability within their country’s small cap universe. The index also excludes those companies with the highest asset growth within their country’s small cap universe. Profitability is defined as operating income before depreciation and amortization minus interest expense divided by book equity. Asset growth is defined as change in total assets from the prior fiscal year to the current fiscal year. The index monthly returns are computed as the simple average of the monthly returns of four sub-indices, each one reconstituted once a year at the end of each quarter of the year. Maximum index weight of any one company is capped at 5%. Exclusions: REITs and Investment Companies. Source: Bloomberg. The calculation methodology was amended in January 2014 to include profitability as a factor in selecting securities for inclusion in the index. The calculation methodology was amended in November 2019 to include asset growth as a factor in selecting securities for inclusion in the index.

February, 2024

The S&P 500 index of large U.S. stocks closed above 5000 last Friday, a record high for 2024

That same day a new client emailed us expressing concern about their account returns last year. Before becoming a client, her family’s low-cost Vanguard U.S. growth stock index declined over 40% the previous year. That costly and painful loss led them to seek professional investment planning.

In 2018 Cindy and Chuck invested their IRAs in a very low-cost Vanguard all-equity US growth fund. They gained around 33% in 2019, then another 60% in 2020, and finally about 13% in 2021. Of course, they were happy with their returns, and kept adding money. Unfortunately, the 2022 loss not only wiped out all they saved up to 2018, but all the gains and additions made through 2019.

Their Vanguard strategy’s cumulative total return over four years declined to around 8% annualized. Historically, that Vanguard growth fund showed an 8.5% annualized from its inception — lower than the US large cap S&P 500 proxy index from 1926, that showed about 10% as an average return.

Cindy expressed her dissatisfaction in her email regarding the 19.2% gross return last year of the IRA accounts and pointed out a lack of trading “activity.” Their report showed 16.2% as their benchmark, and the balanced investment policy planned for a 7% yearly return. Trying to make sense of this before calling, I checked the return of their original Vanguard fund: almost 47%! Even though they were shocked by the huge losses of 2022, they persisted in using that risky product to set expectations.

Cherry Picked Returns

Your ideal strategy is one you trust well enough that you still evaluate it correctly even during the most uncertain and confusing times, and stick with it, so you don’t sabotage your financial security and planning.

It is natural for investors to want strong exposure to the year’s top market performers. The challenge is understanding what portion of past returns was a one-off windfall that should not be expected for planning purposes. Past performance is just that — history. If you weren’t there, you missed it. Viewing expected returns through a “cost of capital” lens can help us penetrate a great fog of market uncertainty and media hype to estimate informed expected returns for modeling planning strategies.

Companies issue equity and debt, otherwise known as stocks and bonds, to raise capital for growing their business. The rate of return on which of the two types of securities they issue depends on both the supply and demand — the return must be sufficiently high to entice investor demand but not so high as to be discouraged from seeking the capital needed to expand and grow. Firms have the choice of choosing the less costly alternative of stocks or bonds. That link between these capital forces means an investor’s expected return is the company’s expected cost of capital. That relationship is:

Investor’s Expected Return = Firm’s Cost of Capital

Understanding this framework may reduce disappointment of missing out on the recent extraordinary returns mostly due to a few U.S. growth stocks. The so-called Magnificent 7 growth stocks grew by 76% in 2023.¹ While the concept of “expected return” may be nebulous to you, does 76% seem like a reasonable cost of equity capital for any firm? Borrowing rates would have to be incredibly high for a business to justify issuing stock based on that expected return. Since the Magnificent 7 companies were certainly able to secure funding at much lower interest rates that year, then 76% cannot be their cost of equity capital. That means it would not be an investor’s expected return for owning them.

Current Cost of Capital Observations

Investors have been chasing returns, paying higher and higher prices for various U.S. growth stocks over the last decade. Many investors anticipate that companies focused on A.I. will expand even more rapidly due to a perceived technological advantage. Accordingly, growth stock prices may surge even higher. Whether we look at U.S. historical price/earnings ratios, price-to-book ratios, equity risk premiums or CAPE ratios (derived by Robert Shiller, a Nobel prize-winning economist), growth stocks in the U.S. as a group are priced near the extreme high end of historical ranges.²

That means, the cost of capital for those stocks is low, and so that investors’ expected return is low or — should be low.

We do not predict an imminent market decline, or a bubble burst. But portfolios concentrated in U.S. growth stocks definitely have lower expected returns for planning purposes. So, if you are retired or planning to retire soon, a well-structured globally diversified portfolio weighted toward shares of companies with higher costs of capital, such as value stocks, is much more likely to provide a better financial experience over the long term.

Conclusion

One key for peace of mind for retirement planning is holding a strategy structured with enough safe asset allocations, especially those income-oriented, to keep you unworried when the risky portion of your portfolio unexpectedly drops. Those who make big changes after experiencing unexpected losses, and repeatedly keep doing it, are telling me they haven’t recognized their true investing risk: themselves.

Your primary objective for any personal investing strategy should not be trying to get rich by making big bets in an effort to out-do legions of smarter investors who are trying, better than you, to do the same thing. More than one former client sabotaged years of planning in their futile attempts. The first objective of professional financial planning as we practice it is to coordinate all your financial resources and manage your investments to protect your financial security, minimizing the likelihood of ever dying poor.

FOOTNOTES

1. Magnificent 7 includes Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, Tesla. Magnificent 7 return based on monthly market cap weighted average returns. Data provided by Bloomberg and calculated by Dimensional Fund Advisors.

2. See for instance, Hardika Singh, “Stocks Are at Records, but Are They Expensive? These Models Have an Answer,” Wall Street Journal (February 11, 2024).

January, 2024

Market predictions could not have been more wrong, defying media speculations. With so many bearish forecasts, 2023’s blockbuster ending was unimaginable.

The Federal Reserve raised interest rates in 2023 at the fastest rate since the 1980s, a regional banking crisis felled Silicon Valley Bank, war broke out in the Middle East, and war continued in the Ukraine. Money markets accounts cumulatively climbed to record levels,¹ as investors waited for a recession that never happened.

In Washington, politicians debated the U.S. debt ceiling and government funding, and at the last minute (once again) avoided a default. Further, Fitch downgraded its US. credit rating, citing the country’s rising fiscal deficits and “the erosion of governance.”²

Exhibit 1: Global Market Overview

Returns of Markets Globally (USD), 1 Year as of December 31, 2013

Source: Dimensional Fund Advisors. Past performance is not a guarantee of future results. Market returns are derived from the stated index. Global Equity Market weights are based on Russell 3000 Index, MSCI World ex-USA IMI Index, and MSCI Emerging Markets IMI Index. Fixed Income Market weights are based on Bloomberg US Aggregate Bond Index component of the Bloomberg Global Aggregate Bond Index. Frank Russell Company is the source of Russell Indexes. MSCI data provided by Morgan Stanley. Bloomberg data provided by Bloomberg. Indices are not available for direct investment. Index performance does not reflect the expenses associated with the management of an actual portfolio.

So What Happened?

U.S. Stocks fitfully kept climbing, gaining 26% on a total return basis. Globally they rose 21.6%. Our modest prognostication for 2023 had been that in 95% of years following U.S. mid-term elections, historical data showed U.S. stocks preformed positively.

US inflation retreated from June 2022’s four-decade high of 9.1%, with the consumer prices falling to 3.1% in November. The Fed made four increases during 2023, but only one occurred in the second half as inflation subsided.

In the bond market, benchmark U.S. Treasuries rebounded after posting their worst annual decline in over a century, with the Bloomberg US Aggregate Bond Index gaining 5.5% after a 12.5% decline in 2022. Moreover, yields (which fall when prices rise) soared. The 10-year Treasury yield nearly touched 5% in October for the first time since 2007, before pulling back below 4% by year-end.

Exhibit 2: Magnificent 7’s Outsized Impact on U.S. Stock Performance

Cumulative Returns, 1 year as of December 31, 2023

Source:Dimensional Fund Advisors. Past performance is not a guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. US and global ex US markets represented by, respectively, the Russell 3000 Index and the MSCI All Country World ex USA Index (net div). Top seven contributors are the top return contributors specific to each index. Russell Company is the source of Russell Indexes. MSCI data provided by Morgan Stanley. The Magnificent Seven is defined as Amazon, Tesla, Apple, Alphabet, Nvidia, Meta Platforms, and Microsoft. This information is intended for educational purposes and should not be considered a recommendation to buy or sell a particular security.

Chance Dominates Realized Returns

Technology stocks recovered from the enormous 2022 declines, driving the tech-heavy Nasdaq up 44.6%.³ Most of the U.S. stock market’s large gains compared to the global market could be attributed to just a small group of companies with a moniker, the “Magnificent 7.”⁴ Relative valuations for those seven stocks climbed to enormous highs, with an aggregate price-to-book (P/B) ratio of 12.7 while the U.S. stock market 30-year average is only 3.05%.⁵ For comparison, the P/B of the US S&P 500 Index was 4.23%, the US Russell 3000 Index was 3.85% and the MSCI All Country IMI Index was 2.58% as of year end.

Valuation theory, as well as the historical evidence suggests that their future returns will become similar to the market. As Exhibit 3 illustrates, companies that become among the largest in the market show very impressive returns. But after joining the Top 10 largest by market cap, those stocks, on average, lag behind the market going forward. From 1927 to 2022, the average return over the three years prior to joining the Top 10 was more than 25% higher than the market. Five years after joining the Top 10, these stocks, on average, underperformed the market. The negative gap was even wider 10 years after. Expectations of future growth of a firm’s returns are reflected in its current stock price.

News pushing prices higher is unpredictable because the timing of that good news is unpredictable. Realized market returns are driven by the difference between investor expectations and events that actually transpire. If reality is better than expected, markets may deliver stronger returns. On the other hand, disappointing developments may lead to worse returns than anticipated.

Exhibit 3: Outsized Performance of “Top Stocks” Unlikely to Continue

Annualized return in excess of market returns for before and after listing as “10 largest” U.S. Stocks

Source:Dimensional Fund Advisors. Past performance is not a guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Data from CRSP and Compustat. Companies are sorted every January by beginning month market capitalization to identify first time entrants into the 10 largest stocks. Market defined as Fama/French US Total Market Research Index. The Fama/French indices represent academic concepts that may be used in portfolio construction and are not available for direct investment or for use as a benchmark.

2023’s big tech stock surprise was impacted by unpredictable “good news” of advances in AI (artificial intelligence). Rather than simply assume those mega cap tech stocks will continue their upward climb, informed investors should maintain broadly diversified portfolios, positioned to capture a portion of the returns from a new set of companies as they unpredictably rise.

The randomness of stock returns among countries around the world makes guessing which country will outperform difficult. Annual returns in 22 major developed markets have varied widely from year to year.⁶ Holding equities from markets all around the world — as opposed to those of only one country — positions investors to better capture a portion of those higher returns wherever they appear. Outperformance in one country helps offset lower returns elsewhere. For example the 28.1% rise in Japanese stocks to an all-time high from September 2022 to the end of 2023 was a big surprise. Japan’s share of the global market cap had declined from 40% to 6% between 1990 and 2022. Those forecasting continued poor returns missed it.⁷

The MSCI All Country World IMI Index returned 21.6% in 2023, as we saw in Exhibit 1. That’s three times its annualized compound return since June 1994. Think about it: We’ve had major geopolitical conflicts and deteriorating fiscal health for many countries, and yet, on balance, outcomes were better than what markets expected for stock prices at the start of last year.

Exhibit 4: Expected Growth vs. Actual Growth of Equity Returns Globally

January 2023-December 2023

Source: Dimensional Fund Advisors. Past performance is not a guarantee of future results. Growth of a dollar shown for MSCI All Country World IMI Index (net dividends). Dollar results presented in the chart are hypothetical and assume reinvestment of income and no transaction costs or taxes. The chart is for illustrative purposes only and is not indicative of any investment. Indices are not available for direct investment. Index has been included for comparative purposes only.

Predictions vs. Realizations

Economic resilience in the U.S. and elsewhere is boosting the global outlook for 2024. But only uncertainty is certain. The upcoming U.S. presidential election that dominates today’s conversation is just one of many factors impacting prices in equity market assets.

We can’t predict what will happen, but good planning considers what can happen. Rather than waste time and effort with guesswork our systematic management allows for a broad range of potential outcomes. More than 30 years ago as an MBA student I unexpectedly found myself in the midst of a scientific revolution in finance. Over the subsequent three decades the old, conventional ways of investing were progressively displaced. My clients living better lives as a result of that great displacement.

FOOTNOTES

1. Source: Morningstar. US domiciled money market funds. $5.9 trillion as of November 2023, previously $4.8 trillion in May 2020, and $3.8 trillion in January 2009.

2. On August 1, Fitch Ratings downgraded the US government’s credit rating to AA+ from AAA (the best possible rating on a scale from AAA to D). Fitch is one of several nationally recognized statistical ratings organizations (NRSROs), along with Standard & Poor’s (S&P) and Moody’s, that publish credit ratings on a wide range of bonds from issuers such as governments and corporations.

3. Based on the 2023 calendar-year return of the Nasdaq Composite Index. Returns are calculated from the total return index values.

4. The Magnificent 7 stocks include Alphabet, Amazon, Apple, Meta Platforms, Microsoft, NVIDIA, and Tesla. Named securities may be held in accounts managed by Dimensional.

5. Due to data availability, the US Market 30-Year Average is as of September 30, 2023.

6. Source: Dimensional Fund Advisors, Matrix Book 2022: Historical Returns Data—US Dollars. Diversification neither assures a profit nor guarantees against a loss in a declining market.

7. Source: Dimensional Fund Advisors, Matrix Book 2022: Historical Returns Data—US Dollars. Market cap data is free float adjusted and meets minimum liquidity and listing requirements. For educational purposes and not used as investment advice. Data provided by Bloomberg. Diversification neither assures a profit nor guarantees against a loss in a declining market.

December, 2023

Contrary to a popular storyline of media commentators, since 1975 stocks have climbed two-thirds of the time in countries whose government debt exceeded 100% of gross domestic product (GDP).

U.S. government debt reached 121% of the value of the country’s gross domestic product last year.¹ Many investors are concerned due to what they hear or read about the potential negative impact that servicing such high amounts of debt could have on their stock portfolios. But historical data of many countries in similar situations over nearly fifty years show little connection between the two.

Since 1975, there have been 153 observations where a country debt/GDP for a year exceeded 100%. During that half century in 104 of 153 periods, stocks were up about two-thirds of the time. For a familiar context, U.S. stocks have performed positively about 75% of the last 100 years over a broad range of domestic GDP ratios.

Examples of countries carrying high debt for extended periods include Italy and Belgium. Both had over 100% debt/GDP ratios in more than 30 of the past 48 years. While internal politics and economies have been troubled, nonetheless their stock markets have returned an average of 10.8% and 12.0% per year, respectively. Japan has had a debt/GDP over 200% since 2010; still, its market returns have averaged close to 6% per year for over 22 years.

Why should this to be so? Active market trading among participants for profit sets prices to the point so that investors have a positive expected return. Also a country’s debt condition is only one of more than a hundred variables. Country debt is an especially slow-moving variable with few surprises. Accordingly, daily market prices should reflect current expectations. So having positive stock performance even amid high-debt conditions should not surprise us.

Exhibit 1: Country Debt Levels Don’t Explain Stock Returns

General government debt, percent of GDP vs. stock market return for developed markets, 1975–2022

Source: Dimensional Fund Advisors. Debt figures are based on General Government Debt data from the Global Debt Database published by the International Monetary Fund. MSCI index returns are net dividends, in USD. Past performance is not a guarantee of future results.

Fed Fund Rate Changes Don’t Change Stocks

Investors frequently worry that rising interest rates will decrease equity valuations and equity portfolio outcomes. However, the data suggests otherwise. Here in the U.S., equity returns typically have been positive following Fed fund rate hikes.²

Let’s compare the relation between U.S. equity returns (measured by the Fama/French Total US Market Research Index) and Federal fund target rate changes from 1983 to 2021. Exhibit 2 presents the average monthly returns of U.S. stocks when there is an increase, decrease, or no change in the Fed target rate. Rates increased in 70 months and decreased in 67 months of 468. On average, U.S. equity returns are reliably positive in months when target rates increase.³ Average stock market returns in those months is similar to the average return in other months without changes in target rates.

Exhibit 2: Reliably Rewarding Outcomes

US equity market returns and Fed funds target rate change, January 1983–December 2021

Source:Dimensional Fund Advisors. Past performance is not a guarantee of future results.

But what about those months after rate hikes occur? Commentators speculate endlessly about whether the Fed will increase the federal funds target rate over a series of months. Exhibit 3 presents annualized U.S. equity market returns over the one-, three-, and five-year periods following one or two consecutive monthly increases in the fed funds target rate, when no increase occurred. Reassuring for investors, the U.S. equity market actually delivered strong longer-term performance, on average, regardless of Fed rate-changing.

Exhibit 3: Ignore Fed Rate Raises

US equity market returns following consecutive Fed funds rate hikes, January 1983–December 2021

Source:Dimensional Fund Advisors. Past performance is not a guarantee of future results.

Watching Fed signals and actions is a popular commentator activity. Because the Fed signals its intentions in advance, trading appears to incorporate that information into market prices by the time a change occurs. While media talking heads speculate what Fed’s actions mean for stocks, the data indicates that U.S. equity markets offers investors positive returns, on average, regardless of Fed rate hikes. So why worry?

The planning insight here is that changing equity allocations in anticipation of, or in reaction to, Fed funds rate changes are unlikely to improve investing outcomes, especially after trading and tax costs. Instead, we recommend maintaining a broadly diversified and consistently allocated portfolio using discoverable information in market prices to gain higher expected returns. That is most likely to keep you well-positioned for gaining the positive planning outcomes you need.

FOOTNOTES

1. “General Government Debt,” Global Debt Database, International Monetary Fund, September 2023.

2. The federal funds rate is the interest rate at which depository institutions lend balances at the US Federal Reserve to other depository institutions overnight.

3. The Federal Open Market Committee (FOMC) holds eight regularly scheduled meetings per year and may not change the target rate at every meeting. The FOMC may also change the target rate multiple times within the same month; in such instances, we aggregate all changes by month.

Index Description: Fama/French Total US Market Research Index: Fama/French Total US Market Research Factor + One-Month US Treasury Bills. Source: Kenneth R. French – Data Library (dartmouth.edu).

Results shown during periods prior to each index’s inception date do not represent actual returns of the respective index. Other periods selected may have different results, including losses. Backtested index performance is hypothetical and is provided for informational purposes only to indicate historical performance had the index been calculated over the relevant time periods. Backtested performance results assume the reinvestment of dividends and capital gains. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book.

Basis point: One basis point (bps) equals 0.01%.

Disclosure: The information in this material is intended for the recipient’s background information and use only. It is provided in good faith and without any warranty or representation as to accuracy or completeness. Information and opinions presented in this material have been obtained or derived from sources believed to be reliable, and have reasonable grounds to believe that all factual information herein is true as at the date of this material.

November, 2023

Aggregate stock market valuation ratios have not been strong predictors of broad market returns in the short or the intermediate term. And yet, high stock valuations sit near the top of concerns cited by investors about the state of today’s equity markets.

However, this perception stems primarily from a subset of U.S. growth stocks. Investors should be careful not to throw the baby out with the bathwater by ascribing this characteristic to their general stock market planning expectations.

The poster child for high valuations — the so-called Magnificent 7 (Amazon, Alphabet, Apple, Meta, Microsoft, Nvidia, and Tesla) — had an aggregate price-to-book (P/B) ratio of 11.89 as of September 30 (despite six of the seven having lower profitability than the S&P 500 Index). To put that in perspective, the average for the US market over the past 30 years is 3.05.¹ The 7 comprise 23.9% of the U.S. Russell 3000 stock index.

The Magnificent 7 helped push up the P/B ratio of the tech-heavy Nasdaq Composite to a high of 5.21. Indices of the broader stock market, especially those with non-US stocks, have substantially lower valuations. For example, the global MSCI All Country World IMI Index P/B is less than half that of the Nasdaq. They comprise only about 10% of that global stock index.

Exhibit 1: Are stocks on sale somewhere?

Aggregate price-to-book ratios as of 9/30/2023

Source:Dimensional Fund Advisors. Indices are not available for direct investment. S&P data © 2023 S&P Dow Jones Indices LLC, a division of S&P Global. Frank Russell Company is the source and owner of the Russell Indexes. MSCI data © 2023.

What should we make of this valuation ratio data? A stock’s price represents the value of a company’s expected future cash flows discounted back to the present. So high valuations can result either from high expectations of future cash flows, low discount rates, or a mix of the two. It’s not possible to cleanly isolate cash flow and discount rate effects from the data. But to the extent that high valuations reflect low discount rates, it’s very likely expected stock returns will be lower going forward for planning long term goals and particularly for the Magnificent 7.

To the extent that widening spreads between indexes are attributable to increases in the discount rates for value stocks relative to growth stocks in particular, the implication is a higher realized value premium for planning purposes. However, much research² suggests investors should be cautious using valuation spreads to methodically adjust holdings for asset allocation. While regression analysis provides evidence of a link between valuation spreads and subsequent value premiums realized, hypothetical timing strategies that methodically switch between value stocks and growth stocks simply based on the relative valuations spread fail to consistently outperform a simple buy-and-hold strategy.

What’s the planning takeaway? Investors demand different expected returns across stocks. Although spreads in valuations vary through time, the very large spread driven by growth stocks, especially in the U.S. should not be ignored. It’s reasonable to expect that securities with lower prices relative to market fundamentals should have higher expected returns for long term investment management.

While value premiums in the U.S. or internationally may not show up every day, or even for a decade, we believe maintaining a consistent allocation exposure with a value emphasis is the most informed approach and is more likely to be rewarded consistently. Our portfolio strategies are dimensionally structured to reliably capture the value premium whenever it appears, and to mitigate negative outcomes during inevitable periods of downward market adjustments.

FOOTNOTES

1. Average P/B ratio for the Fama/French Total US Research Index from October 1998 through September 2023.

2. Wei Dai, “Premium Timing with Valuation Ratios” (white paper, Dimensional Fund Advisors, 2016).

September, 2023

Active investors such as hedge fund managers continually seek an informational edge for market trading. That includes using artificial intelligence (AI) to retrieve and process data attempting to make more profitable trades. Tools similar to AI that gauge sentiment from social media or scrape text from company financial reports long predate ChatGPT.

Any information gleaned from running an AI process that may be “material” most likely is a subset of a vast information set already known by “material” market participants (many likely with their own AI process). In “efficient” markets, information is almost instantly reflected in individual and aggregate market prices through the process of buying and selling securities. If by chance AI detects “new” information, an investor or his AI device acting on that information instantly incorporates that new tidbit as a price into that vast information processing array that we describe as “The Market.”

Markets gather all the dispersed information known or knowable about a company or sectors of companies. Market participants actively evaluate the impact of any new information. They assign their own value based on that information. Almost instantly that value gets expressed as a price as shares trade in real time. That internet-linked web of endless global interconnections, in effect, is artificial intelligence. And no government formally arranged it.

AI’s limitation in securities transactions is its inadequate predictive ability. AI’s forecasting ability works well when assessing patterns that are relatively stable or with set rules, such as in chess games. Activities in financial markets, by contrast, are fantastically complex and keep changing — so much so that no one can precisely guess how much or in what way another particular piece of information coming along may impact prices. Thousands of other inputs (if not tens of thousands) are all interacting simultaneously. AI processes trying to predict particular market prices are like self-piloting cars attempting to read stop signs with words, shapes, and colors that change every day.

Consider the AI-Powered Equity ETF, launched in 2017. It employs IBM Watson’s AI to analyze publicly available information to identify US stocks to buy or sell that hopefully would outperform US market returns (Exhibit 1). You may recall that an early version of Watson, “Deep Blue,” was a chess-playing expert system run on a unique purpose-built IBM supercomputer. It was the first computer to win a chess game, and the first to win a match against a reigning world champion under regular time controls.

Exhibit 1: AI Powered Equity ETF vs. Russell 3000 Index and S&P Technology Select Sector Index

Cumulative returns, November 1, 2017–May 26, 2023

Source:Dimensional Fund Advisors and FactSet. Sample period begins with the first full month of returns for AI Powered Equity ETF. Past performance is not a guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Frank Russell Company is the source and owner of Russell Indexes. S&P data © 2023 S&P Down Jones Indices LLC.

While Watson can outwit even the best individual chess master, its intelligence pales in comparison to the aggregate wisdom created by a million individuals competing for profit making daily stock market trades. We are unsurprised then that the Watson-powered ETF lags broad US market returns and, by a much wider margin, US technology sector returns since its inception about five years ago.

Sure, AI can improve technical aspects of trading execution. But the aggregated market intelligence of many independent participants is powerful and ensures the price at the time a trade is made fairly represents the true value of each stock or bond based on all that is known or knowable at that moment. There’s no reason to think that AI fundamentally should revise our trading methods substantially anytime soon.

Better Planning to Pursue Better Outcomes

We expect positive premiums in our equity portfolios every day. But decades of market data show that unexpected returns dominate the performance we see daily, monthly, quarterly, and annually. Many numerical changes in reports are, essentially, statistical “noise” making account statements confusing. Ignoring daily, monthly, quarterly, and even annual return vagaries among funds that deliver equity returns is often necessary for a systematic investing process to be successful.

Premiums that drive better long-term outcomes can turn around quickly and unpredictably. They are easily missed without consistent representation in an informed portfolio allocation structure. If they are missed, returns that you may have waited months or even years for, but then suddenly quit due to lack of discipline — distracted perhaps by better-seeming recent returns elsewhere — are gone forever.

Examining annualized return premiums derived from financial science going back decades, shows that small cap stocks have beaten large cap stocks, value has outperformed growth, and high profitability stocks have outgained low profitability stocks over long periods. How should you think about the performance of these premium dimensions¹ over shorter time periods for more informed planning of your most essential goals?

Exhibit 2: Frequency of Small Cap, Value, and High Profitability Outperformance

Past performance is no guarantee of future results. Investing risks include loss of principal and fluctuating value. There is no guarantee an investment strategy will be successful. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Source: Dimensional Fund Advisors. Number and percentage of quarters where market, size, value and/or profitability premiums were negative are calculated using monthly return data from July 1963 to March 2023. Market: Fama/French Total US Market Research Index minus the one-month US Treasury bill. Size: Dimensional US Small Cap Index minus the S&P 500 Index. Value: Fama/French US Value Research Index minus the Fama/French US Growth Research Index. Profitability: Fama/French US High Profitability Index minus the Fama/French US Low Profitability Index. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. The Dimensional and Fama/French Indices represent academic concepts that may be used in portfolio construction and are not available for direct investment or for use as a benchmark. Index returns are not representative of actual portfolios and do not reflect costs and fees associated with an actual investment.

Exhibit 2 supports the economic philosophy we believe will be most successful. The data show a multi-factor approach based on premium dimensions for investment management not only likely to outperform a simple indexed arrangements (popular with Vanguard) but also actively managed funds, EFTs and other schemes that pick stocks.

Performance during overlapping periods formed each month (e.g., January to December, February to January, etc.) over rolling periods of one, five, and 10 years, show these premium dimensions were positive over most one- and five‑year periods. They continue to increase over longer stretches. The value dimension, for instance, beat the growth dimension in 80% of 1,027 measurable 10-year periods.² We reasonably infer for planning beyond rolling 10-year periods that calculations would improve closer to 100%. Of course, no investing period, however long, can provide certainty of realizing all the premiums.

Conclusion

The so-called Fama-French three-factor model (now with five factors) has proved itself in academia over the past three decades as the best economic model for estimating expected stock returns. It is an informed framework for organizing expected equity returns in an intuitive way. It has a risk story that makes sense for planning purposes: small and value stocks as a group have higher expected returns than big and growth stocks. They do so because we believe they have more risk. Bearing such risk consistently should reward an investor with higher returns over the long-term when they stick with a dimensionally diversified strategy.

No model is literally true, of course. But the dimensional multi-factor model Professional Financial has applied for almost thirty years has systematically guided better planning for our clients and helped us avoid many serious investment mistakes others have made chasing returns. Systematically targeting size, value and profitability premiums for our portfolio equity allocations gives your planning focus in uncertain times. Along with maintaining the right lifestyle and insurance, your odds of realizing a lifetime of financial security for you and those you care deeply about are dramatically improved. And most of all, planning with CFP® professionals can offer greater peace of mind.

NOTES

1. Based on monthly rolling returns, computed as follows: Dimensional US Small Cap Index minus S&P 500 Index, June 1927–December 2021; Fama/French US Value Research Index minus Fama/French Us Growth Research Index, July 1926–December 2021; and Fama/French US High Profitability Index minus Fama/French US Low Profitability Index, July 1963–December 2021. Size premium: The return difference between small market capitalization stocks and large market capitalization stocks. Value premium: The return difference between stocks with low relative prices (value) and stocks with high relative prices (growth). Profitability premium: The return difference between stocks of companies with high profitability over those with low profitability.

2. Small vs. Large: 1,124 periods of 1 year; 1,076 periods of 5 years; 1,016 periods of 10 years. Value vs. Growth: 1,135 periods of 1 year; 1,087 periodsof 5 years; 1,027 periods of 10 years; High Profitability vs. Low Profitability: 691 periods of 1 year; 643 periods of 5 years; 583 periods of 10 years.

August, 2023

The probability of experiencing positive returns from informed stock investing increases over time.

An allocation to a value-weighted group of US large stocks grew wealth during 75% of the one-year periods between January 1926 and May 2023; however, 25% of those years had negative outcomes. Over ten-year periods, positive outcomes occurred 95% of the time; only 5% were negative. No period exceeding 184 months (just over 15 years) shows a negative return based on US market data, but even that outcome is not assured over any time period.¹

Stocks do not become less risky in the long run. The range of potential stock market outcomes over a multi-year period is wide. The year-end value of a dollar invested in a value-weighted group of US large cap stocks over one-year periods between January 1926 and May 2023 has ranged from $0.32 to $2.63. Over a much longer 20-year horizon, the gap between worst- and best-case scenarios ranged from $1.45 to $28.62.¹ (See Exhibit 1.) The cumulative difference is more than 2,700 percentage points for the very same asset class!

The huge dispersion possible among US stock outcomes (even pretending that the index funds were always available) means stock investing should not be considered “safe” over any horizon. But equity investors — those with long-term wealth goals and a disciplined approach — can have a much greater confidence of success by employing an informed allocation strategy such as those planned by Professional Financial.

Exhibit 1: Long-Term Performance in US Equities Varies Widely

Historical growth of a dollar outcomes in the S&P 500 lndex, January 1926-May 2023

Source:Dimensional Fund Advisors. Past performance, including hypothetical performance, is no guarantee of future results. Growth of $1 computed over rolling monthly periods for the S&P 500 Index assumes reinvestment of income and no transaction costs or taxes. Outcomes are reported for the minimum and maximum of these observations. The analysis is for illustrative purposes only and is not indicative of any investment. S&P data © 2023 S&P Dow Jones Indices LLC. Indices are not available for direct investment.

The Danger of Planning from Cherry-picked Periods

Anyone who’s ever bought a used car is aware what a cherry-picked driving history could mean. Low mileage and regular oil changes matter little if the seller conceals that the car was once submerged in floodwater.

A recent investor focus of concentrating on a few high-performing stocks has become popular. For those more careful, funds focused on variations of S&P 500 large cap stocks are popular. Since 2010, large cap S&P 500 stocks outperformed US small cap value stocks² by 1.7 percentage points annualized. However, those that find S&P 500 stocks so appealing are almost wholly unaware that a “lost decade” from January 2000 to December 2009 preceded the years since 2010. An index of those same large company stocks showed a negative 0.9% annualized return for ten years — trailing an index of today’s less popular US small value stocks by more than 13 percentage points annually!

More extensive data histories improve our planning perspective. Historically since June 1927, US small cap value stocks have outperformed the S&P large company index by 3 percentage points annually — 13.1% to 10.1%. This is sensible since small cap stocks like Canandaigua Wine are riskier than large cap stocks like Apple or Microsoft. There are many return periods of the S&P 500 with aberrations like the “Lost Decade.” Losing to small cap value stocks over 14 years while returning less than zero during 10 years is an unlikely long-term outcome. But those things happen, and variations are always possible.

Exhibit 2: Using Outliers to Plan Informs Wrong Expectations

Annualized returns for the S&P 500 Index and Dimensional US Small Cap Value Index

Source:Dimensional Fund Advisors. Past performance is no guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. S&P data © 2023 S&P Dow Jones Indices LLC.

Concluding Observations

Harry Markowitz’s portfolio theory goes back to the 1950s, for which he was awarded the Nobel prize. The theories of Bill Sharpe and others that followed, were foundational in the development of today’s professional investing process. Capitalizing on Markowitz’s game-changing concept, though vastly improved today, clients have far greater confidence of realizing successful planning outcomes than was possible before the 1970s.

Markowitz’s theory profoundly shifted investor thinking from routinely making “bets” picking individual stocks or funds to assessing risk/return holistically and managing long-term strategies. For example, small cap stocks can have higher volatility than individual large cap stocks. Yet when both small cap stocks and large cap stocks are allocated as cap-weighted portfolios in a sensible manner, the increased diversification benefits of the combined portfolios, meaningfully reduces standard measures of portfolio volatility for both.

Rather than concentrate on savoring a single raw flavor, a great chef evaluates an ingredient’s contribution to the entire dish. He understands that the whole is greater than the sum of its parts. Successful investment management practiced here at Professional Financial does much the same thing.

NOTES

1. Growth of wealth computed over rolling monthly periods (1 year, 5 years, 10 years, 15 years, 20 years) for the S&P 500 Index. Percentages stated indicate periods with a positive gain. Dollar amounts are the lowest and highest historical results within each time range.

2. US small cap value stocks represented by the Dimensional US Small Cap Value Index. The index is defined as companies whose relative price is in the bottom 35% of the Dimensional US Small Cap Index (a market-capitalization-weighted index of securities of US companies whose market capitalization falls in the lowest 8% of the total market capitalization of the eligible market) after the exclusion of utilities, companies lacking financial data, and companies with negative relative price. The eligible market is securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market. Exclusions: non-US companies, REITs, UITs, investment companies, and companies with the lowest profitability within the small cap value universe. The index excludes companies with the highest asset growth within the small cap universe. Profitability is defined as operating income before depreciation and amortization minus interest expense divided by book equity. Asset growth is defined as change in total assets from the prior fiscal year to current fiscal year. Data source: CRSP and Compustat.

The Dimensional US Small Cap Value Index has been retrospectively calculated by Dimensional Fund Advisors LP and did not exist prior to the index inception date. Accordingly, results shown during the periods prior to the index inception date do not represent actual returns of the index. Other periods selected may have different results, including losses. Backtested index performance is hypothetical and is provided for informational purposes only to indicate historical performance had the index been calculated over the relevant time periods. Backtested performance results assume the reinvestment of dividends and capital gains.

June, 2023

KEY TAKEAWAYS

• The debt ceiling is the amount of money Congress has authorized the government to borrow. The ceiling has been raised 78 times since 1960.
• While resolving the debt ceiling fight is unclear, it is only one of many factors that impact security prices.
• An informed mix of diversified equity and fixed income investments is the best long-term approach for handling uncertainty.

If continuous debate over the debt ceiling gives a sense of déjà vu, well, we’ve seen this before. The Federal debt ceiling, or limit, reflects the amount of money the United States Congress has authorized the government to borrow. Congress authorizes such increases about the time the previous authorized limit has been reached. Congress has acted to raise the debt ceiling 78 distinct times since 1960.¹ Occasionally, policymakers have struggled to reach consensus.

The US effectively reached the debt limit back in January, triggering “extraordinary measures” by the Treasury Department to continue servicing existing debts and obligations. But Treasury Secretary Janet Yellen has warned about an “X-date” when “extraordinary measures” may be exhausted.² As the X-date approaches, many wonder how a breach of the debt ceiling could impact their saving and investing strategies.

While daily media attention may worry you, negative outcomes are not certain. Historically, Congress has always raised the debt limit, and even if Congress failed to increase the limit by the X-date, unless you receive a government salary, your impact may be muted. Interest and principal payments on federal debt for those relying on such vehicles will be paid timely. But trying to predict possible scenarios is unnecessary, given that investment markets have already priced in a range of outcomes. Looking beyond the speculation and sticking to an sensible investment plan is likely the best plan.

Prices over Pundits

Until the political path clears, heightened volatility in both the equity and fixed income markets may be observed. But many factors beyond politics impact security prices. In the debt ceiling crisis of 2011, US Treasury yields declined during the period surrounding the culmination of the tense negotiations that resolved in August of that year (see Exhibit 1), despite S&P downgrading the credit rating on US sovereign debt from AAA to AA+.³ This is the very opposite of what you might suppose. The rewards for holding long-term fixed income instruments increased during that time.

Exhibit 1: Falling Yield

Daily 5-Year US Treasury Yield, 2011

Source: U.S. Department of the Treasury. Past performance is no guarantee of future results.

Flexibility over Forecasts

Market volatility is only part of investing risk. Accepting uncertainty long-term and sticking with your plan is essential to earning unpredictable risk premiums. Planning with a flexible and adaptive investment process navigates volatile market environments for those staying focused on their planning goals. Selling out during a market jump could compromise years of progress when a reversal unexpectedly occurs.

Our approaches have built-in flexibility and this enables managers of your portfolios to adapt to changes in market prices or credit spreads in real time. That includes, for example, avoiding unnecessary trading during times of heightened volatility. Certain types of investment strategies, like traditional indexing, have constraints limiting their flexibility due to their forced tracking to a particular index regardless of changing market conditions.

Designing flexible investment portfolios and processes gives portfolio managers and traders additional tools to skillfully manage ongoing risks, potentially reduce costs, and maintain a focus on higher expected returns even during times of heightened market volatility. This year, measures of interest rate volatility on US Treasury securities have been elevated (see Exhibit 2) but are integrated into managing our client portfolios.

Exhibit 2: Interesting Times

Interest rate volatility on US Treasury securities, 1988–April 30, 2023*

Source:Data sourced from Bloomberg on May 18, 2023. ICE BofA index data © 2023 ICE Data Indices, LLC.
Based on ICE Bank of America MOVE Index, a yield-curve-weighted index of normalized implied volatility on 1-month Treasury options. Past performance is not a guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.

Diversification over Debates

When uncertainty has increased, flexible diversification is a most important risk management tool. Although a US government technical default likely would temporarily shock markets globally, we believe our informed systematic balanced equity and fixed income allocation approach with Dimensional Fund Advisors – based on your investment policy – is your most reliable way to successfully ride out a coming storm.

NOTES

1. “Debt Limit,” US Department of the Treasury.

2. “Debt Limit Letter to Congress Members,” US Department of the Treasury, May 15, 2023.

3. Credit rating agencies like Standard & Poor’s Corporation (S&P) rate the credit quality of debt issues. S&P’s scale is from AAA to D with intermediate ratings of (+) or (-) offered at each level between AA and CCC.

May, 2023

The Federal Reserve Bank once again raised its rate another quarter point. It signaled that that may be the last increase for a while. A series of rate increases are the Fed’s effort to lower current high inflation while keeping employment full. Impact on the US dollar, a global reserve currency, is not their concern even though it has declined this year.

For several years, the Federal Reserve has actively responded to prevailing economic conditions. Consequently, fixed income investors have become increasingly focused on what the Fed may do. While predicting any Fed’s action is uncertain, data show that markets quickly incorporate any news related to Fed decisions into fixed income prices. Patterns in the pricing of Fed Funds futures contracts support this notion. Federal Fund futures contracts are financial instruments that capture market participants’ aggregate expectations of the future path of Fed funds rate changes.

Exhibit 1 below shows that many months prior to the Federal Reserve’s meeting last March, market participants used futures contracts to hedge against future potential adverse outcomes. During the twelve months leading up to the Fed’s announcement, for instance, CME Group used March 2023 future prices to assign probabilities to given Fed Fund rate changes. This exhibit uses probabilities of rate ranges to calculate a market-implied Fed Funds rate for the March 22 date that aggregates the expectations of all market participants. You can see how market prices converged due to improved information over time. What started as a wide range of expectations back in March 2022, gradually narrowed in months and weeks leading up to the March 23, 2023 announcement. However, over the course of the full period, incoming news in one way or another caused pricing bumps.

Exhibit 1: Markets Work to Help Predict Future Interest Rates

Range of participant expectations for March 2023 Federal Funds Rate, March 2022-March 2023

Source: CME Group. Market Implied Fed Funds Rate is based on probabilities of a given target Fed funds rate range from corresponding CME Group Fed Fund Futures Contracts. Range of Participant Expectations is the corresponding expected future interest rates where the probability is not zero.

You may be concerned that continued rate hikes could negatively impact your fixed income allocation’s total return. While forecasting the paths of interest rate change is largely educated guesswork, consider that higher yields resulting from continued change would mitigate fixed income capital losses incurred. Exhibit 2 is a matrix showing the impact of hypothetical rate increase scenarios on fixed income vehicles over longer maturities. Notably, even if rates increased by another 100 bps, a bond with a 7-year duration still could generate a 1.02% positive total return when held to maturity.

Exhibit 2: Evaluating Rate Increase Scenarios

Comparing 1-YR total returns for a range of maturities in different rate increase scenarios, initial yield of 5%

For illustrative purposes only. The matrix computes the realized total return for a bond with a 5% coupon rate paid annually and a 1-year holding period. The matrix illustrates the impact of a hypothetical interest rate change at the beginning of the holding period, for a given maturity, assuming a parallel shift in the curve. Data presented are based on mathematical principles, are not representative of indices, actual investments or actual strategies managed by Dimensional, and do not reflect costs and fees associated with an actual investment. Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Source: Dimensional.

The speed of U.S. interest rate hikes between March 2022 and May 2023 is the fastest increase in decades. Today, the Fed Fund’s Target Rate Range sits at 4.75%-5% after 25 basis point increases in February, March and April. While these recent bumps indicate a slower pace in rate rises compared to the dramatic series of rises during 2022, there is no reliable way to determine whether that trend will continue, or when it will decline.

What we know for sure is that markets will continue to set price expectations in real time. We also know that information using sophisticated risk management tools employed by Dimensional Fund Advisors target higher expected returns for client strategies. Coupling this approach with a variety of fixed income solutions having variable maturity approaches within informed investment management strategies can help you achieve your retirement income goals with greater confidence than playing a guessing game on your own.