How equity premiums improve your expected investment returns
By James Parkyn
At PWL Capital, we take an evidence-based approach to investing that relies on peer-reviewed research by leading academics who have drawn insights from decades of market data.
At the core of our approach is a large body of research that shows a broadly diversified portfolio of passively managed investments is the best way to capture market returns with the lowest possible risk.
To achieve this, we construct globally diversified portfolios using low-cost index funds that reflect the risk tolerance of our individual clients. We then rebalance them periodically to bring asset weightings back to agreed targets.
Another aspect of our approach is to tilt equity portfolios toward factors that have been shown to produce greater expected returns.
Factors expected to produce premium returns over time are as follows:
Market premium: Stocks tend to outperform risk-free government bonds (short-term U.S. Treasury bills).
Size premium: Small stocks tend to outperform large stocks.
Value premium: Value stocks tend to outperform growth stocks.
Profitability premium: Stocks of highly profitable companies tend to outperform those of companies with low profits.
A recent paper from Dimensional Fund Advisors looked at how these equity premiums have performed over 10 years to the end of 2022. (Dimensional is a fund manager that uses financial science to add value to fund performance, including by emphasizing the factors listed above. We use select Dimensional funds in our portfolios.)
The Dimensional paper found that in the 10-year period to the end of 2022, high-profitability stocks generally outperformed low profitability stocks and small cap stocks outperformed large caps outside the U.S.
The group of stocks that underperformed globally during the decade was value, a fact that’s attracted a lot of attention from market observers. Despite a strong rebound from late 2020 through 2022, the MSCI world value index delivered a 7.25% annualized return versus 8.49% for MSCI’s total market world index.
The paper observes that it’s not uncommon for one premium factor to underperform over a 10-year period. However, in looking at data back to 1963, it’s much rarer for two of them to underperform over that length of time and there are no instances when three or four underperformed the market.
It notes that “while a positive premium is never guaranteed, the odds of realizing one are decidedly in your favour and improve the longer you stay invested…Furthermore, premiums can materialize quickly, so you want to be properly positioned to capture the returns when they show up.”
A recent article by our colleague Raymond Kerzérho reminded us of the importance of capturing returns from small cap stocks as part of a fully diversified equity portfolio.
Raymond, Senior Researcher and Head of Shared Services Research at PWL, looked at the performance of funds that track the total U.S. market index versus those that track the S&P 500. The key difference between the two is that the CRSP Total Market Index holds over 3,800 U.S. stocks, including small- and mid-cap equities, while the S&P 500 holds roughly 500 large-cap stocks.
Since the launch of the S&P 500 Index in March 1957 to June 2023, the total market index has outperformed the S&P 500 by a very small margin of 0.03%. The CRSP Index returned 10.48% while the S&P500 returned 10.45% on an annualized basis.
Despite this small difference in performance, we know that adding small-cap stocks to your portfolio not only adds diversification but increases its expected return going forward. This is a key reason why we use the Vanguard U.S. Total Market ETF in client portfolios.
What’s more, as Raymond writes in his article: “…at the margin, a small number of winning stocks explains the long-term market performance; thus, we prefer not to miss out on these stocks.” By including small-cap and mid-cap stocks, you increase the odds of holding the companies that grow into the next large-cap winners.
“The risk of missing out on the high return stocks was highlighted in 2020 when the S&P 500 Index committee failed to include Tesla’s shares in the index until December after the share’s price had increased by 400%,” Raymond writes.
We tilt portfolios to capture equity premiums as part of our commitment to adding value to client portfolios. Over the long term, even small gains can make a significant difference to your wealth.
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