Passive vs Evidence Based Investing
The passive investor believes that stock market prices are always correct, and all available information is in the price. The only way for the price to materially move higher or lower, is on the basis of new information, that is instantly incorporated into market prices. Therefore, because there is no advantage for the active manager to add, one should simply index. This is the basis for passive investing, and it has certainly worked out for many in the 2009-2021 period. However, it still begs the question, is this the best way to invest? Is it investing at all? Is it instead speculation? I would argue no, it is not the best way to invest, and in fact I will go as far as to say that it is not investing per se. it is in fact a call option on the market factor. In order to invest passively, I must ignore the last 50 years of investment research and everything we know today about markets.
The fact that markets efficiently incorporate information is not in question here. While there can be disagreements as to the degree of informational efficiency, what is in question is the best way to target alpha in an efficient market. It is clear from the evidence that stock picking has limited success and is not a dependable way to produce alpha. Indexing however, also has many flaws. Academic research forces us to take a deeper look at how to optimize portfolios to reach investors objectives. Assuming our objective is the maximum growth of capital, the research tells us that, over long measurement periods, investors would be far better served by tilting their portfolio towards the factors of outperformance, and embracing the tracking error that comes with it.
The seminal paper providing evidence for capturing these factor premia was Eugene Fama & Kenneth French's landmark study, which gave us the three-factor model, which eventually grew to five factors. Fama and French identified the market factor, the size factor, the value factor, and later added the quality factor, and the investment factor as determining the cross section of returns for equity investors. Bond investors can add or subtract premia by adjusting their term or default risk as this chart shows.
One of the largest criticisms of the size premium is that it is not robust enough to warrant inclusion in a multi-factor approach to investing. Some have also made the argument that the declining number of stocks in the market has been decreasing and that phenomenon is reducing or even eliminating the small cap premium. The evidence says differently.
Fama and French put forth the notion that over time small cap stocks will beat large cap stocks, and value stocks will beat growth stocks. Thus, small cap value stocks should beat large cap value stocks. Yet few investors include a small cap value fund in their portfolios and the ones who do, "tilt" in a way that fails to capture the additional returns that come from this factor strategy. Simply including it in the portfolio is a good first step, but it is not enough. The factor targeting process is the act of calculating your total exposure to factor premia at a certain level of risk that is acceptable to you, the investor. The idea being that some investors may not be comfortable with the volatility that comes with a full exposure to the small cap premium for example and are willing to settle for capturing a smaller % of the alpha that comes from the size premium for a lower level of risk.
When constructing a portfolio with a growth objective, an investors overall risk tolerance must be a key driver of the portfolio construction process. Assuming that one has the time horizon and risk tolerance to withstand the additional volatility, a 100% Small Cap Value strategy would be most in line with academic research.
However, I know few investors who could withstand the ups and downs of this strategy, nor do I know many investment advisors who are willing to shoulder the burden of placing their clients in such a volatile strategy. Still, the evidence proves that doing this will generate the highest long term investment returns, assuming academic research will continue to be proven out in the returns of the market.
Beware of Differences in Index Construction
A basic deconstruction of index options for tracking the small cap market shows there are important differences that investors need to be aware of, as it could affect their forward-looking returns. Let's take apart what differentiates the Russell 2000, the CRSP index, and the S&P 600. Understanding these differences will help investors choose which index is best for them.
The Russell 2000
The Russell 2000 captures the entire small cap market, but in so doing it captures a large percentage of firms that are not profitable. It also skews its holdings towards mid cap stocks, and away from small and micro-cap stocks which are the source of the size premium.
The CRSP Small Cap Index (Vanguard Small Cap Index)
The CRSP Small Cap Index, represented by the Vanguard Small Cap Index (VB) also skews its holdings towards higher market cap weighted issues in the mid cap section of the index. This suppresses the factor premia that investors will realize because of a lack of exposure to the source of that premia, namely, small and microcap stocks.
The S&P 600 Index
The S&P 600 is probably the second-best index product on the market behind the S&P 600 value index (IJS), or (VIOV). What makes S&P so special is the process that goes into constructing their index. They eliminate a large cross section of the "smid" cap market, choosing largely to focus on its target section of the index, the small and micro-cap area. Because it has a greater exposure to the size premium, it has generated higher returns, but that's not the whole story. Because the index also imposes a quality filter, it knowingly, or unknowingly is providing investors a cutting-edge product which incorporates four fundamental factors, market, size, value, and quality. When taken together this explains the vast outperformance for the S&P index over both the Russell 2000, and the CRSP index.
The results are, as it would have been predicted given the construction of the index, superior making it nearly impossible to beat. Look at the following table from 2001-2022*.
*(Date chosen goes back to the inception of the Russell 2000 index fund IWM)
Small Cap Premium in the Market 2001-2022
Russell 2000 Index | IShares Russell 2000 Index (IWM) | 7.31% |
S&P 600 Index | IShares S&P 600 Index (IJR) | 8.82% |
CRSP Small Cap Index | Vanguard Small Cap Index (NAESX) | 8.32% |
DFA Small Cap | DFA US Small Cap (DFSTX) | 8.80% |
DFA Microcap | DFA US Microcap (DFSCX) | 9.43% |
What we see from this analysis is that the composition of a given strategy will determine how much of the size premium is captured by investors. The DFA Small cap, DFA Microcap, and S&P 600 Index are all factor indexes that capture significantly more premium than the traditional Russell 2000 index giving investors and their advisors much to consider when choosing to include small caps in a long-term diversified portfolio.