February, 2022
KEY TAKEAWAYS
- Capturing size, value, and profitability premiums requires specialized expertise.
- Emphasizing one premium over another or one region over another based on magnitudes of expected premiums from samples of history has potential problems.
- An integrated core approach among multiple premium interactions tied to security weights offers more reliable outperformance, better risk control, and lower costs.
Targeting size, value, and profitability premiums in equity portfolio found by researchers is only the beginning of planning an informed investment strategy. Incorporating persistent and pervasive premiums into equity strategies and doing it well raises critical portfolio construction questions. What is the best structure for capturing drivers of factor returns: a combination of single factor portfolios, a market-satellite combination, or an integrated solution? What is the most workable weighting arrangement? Dimensional Fund Advisors has published a series of papers specifically examining these and related questions.
“Assessing the Relative Magnitude of Premiums”1 evaluates whether the size, value, and profitability premiums differ in magnitude across regions. Using various statistical tests, their studies showed no reliable differences in the expected premiums, either individually or jointly, across U.S., developed ex U.S., and emerging markets. They further examined whether premiums vary across dimensions by region: Is the size premium reliably different from the value premium? Is the value premium reliably different from the profitability premium?
Tests did not show reliable differences across premiums within any region or globally. Therefore, while allocating across premiums and regions to meet investment goals and constraints is sensible, favoring one premium over another or one region over another based on the magnitude of the expected premiums most likely will be a biased decision.
Once an overall allocation approach is determined, how should a portfolio be structured to obtain desired exposure to drivers of return? Three possible options could be: combining the market portfolio with single factor portfolios, combining the market portfolio with a satellite multifactor portfolio, or using an integrated core portfolio approach that simultaneously targets the size, value, and profitability premiums across the entire market.
These approaches were compared in “Pursuing Multiple Premiums: Combination vs. Integration.”2 Results showed that the integrated core approach better accounted for the interactions among multiple premiums and lead to more reliable outperformance, better risk control, and lower costs. These benefits are critical for the most effective pursuit of multiple premiums and cannot be replicated through standard asset allocation approaches.
Exhibit 1: The Impact of Integrating Multiple Dimensional Premiums
Estimating probability of outperforming the MSCI All Country World IMI Index
Source: Dimensional Fund Advisors. For educational purposes only. Past performance is no guarantee of future performance. Estimated probability of outperformance is computed by performing twenty thousand bootstrapped runs of monthly returns from June 1994 to December 2018. For each return comparison, returns are bootstrapped jointly for the MSCI All Country World IMI Index (gross div.) and tilted global all cap portfolios, and the probability of outperformance is calculated as the percentage of sample return trajectories in which the annualized compound return of the tilted portfolio is greater than that of the MSCI All Country World IMI Index (gross div.). The simulations account for the impact of unknown expected returns following the methodology of Fama and French (2018). Integrated represented by Dimensional Global Adjusted Market Index. Size tilt: Emphasizes stocks in the Integrated index with lower market capitalization. Value tilt: Emphasizes stocks in the Integrated index with lower price-to-book ratio. Profitability tilt: Emphasizes stocks in the Integrated index with higher profitability. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. These returns are calculated retrospectively with the benefit of hindsight. The projections or other information generated by bootstrapped samples regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Results will vary with each use and over time. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Does not reflect impact of taxes.
How individual stocks should be weighted in systematic portfolios is another structural decision. “Weighting for the Right One: Weighting Scheme Design for Systematic Equity Portfolios”3 compared eight frequently used weighting schemes by managers and highlights the aspects that most deserved attention. A close link between security weights and market prices proved important. The study showed that when prices are ignored, as in the cases of equal weighting, rank weighting, z-score weighting, and inverse volatility weighting, uncontrolled overweights in the smallest names lead to nonsensical underweights in the biggest names as a result. Some small cap stocks could be overweighted by 50 or even 100 times their market cap weights while companies with the largest market cap stocks, like Apple, could be held at only a few basis points.
Extreme deviations from market weights as we frequently find in ivory tower papers can produce stunning outcomes in theory, but they don’t survive real-world high turnover and trading costs. Simple price-based weighting scheme such as indexing mitigate such issues. But designing a truly robust weighting scheme focused on size, value and profitability premiums requires much more. In price-based weighting schemes, an integrated core approach was identified as most effective at coordinating multiple premiums, managing risks and costs, and allowed for multiple objectives and practical considerations.
Many firms have introduced a wide array of “factor” funds over recent years as “factor investing” has become a highly popular approach to compete for ever elusive investor dollars. But the most informed decision you can make is the one choosing the right way to go about it. That requires a firm with decades of experience in capturing those powerful drivers of expected returns. After all, factors are only the foundation of portfolio design. As Nobel laureate Myron Scholes once said, “Ideas alone are cheap — implementation is what really counts.”
NOTES
1Black, Stanley and Dai, Wei, “Assessing the Relative Magnitude of Premiums” (December 14, 2021). Available at SSRN: https://ssrn.com/abstract=3981766
2Dai, Wei and Saito, Namiko and Watson, Stephen, “Pursuing Multiple Premiums: Combination vs. Integration” (February 26, 2021). Available at SSRN: https://ssrn.com/abstract=3793594
3Dai, Wei and Saito, Namiko and Wang, Gigi, “Weighting for the Right One: Weighting Scheme Design for Systematic Equity Portfolios” (February 2, 2022). Available at SSRN: https://ssrn.com/abstract=4016481