Warburton Capital’s Evidence-Base Investment Insights
The Factors That Figure In An Evidence-Based Portfolio
Last week a buddy came in to share an exotic tactic ‘guaranteed by him’ to generate out-sized returns. It was pretty cool and involved ‘Shorting Venezuelan Bovine Futures’ while ‘Going Long Russian Rubles’. As regards ‘exotic’ this pretty much sets a new World Record! We listened patiently before proceeding with our side of the dialogue which went something like ‘Granted, this tactic might or might not work…only time will tell. That said, for a more reliable methodology…let’s take a look at the objective academic evidence which reveals what factors lead to a portfolio based on evidence rather than conjecture’.
Welcome to this the ninth installment in Warburton Capital’s series on Evidence-Based Investment Insights: The Factors That Figure In An Evidence-Based Portfolio.
In our last piece – The Essence of Evidence-Based Investing – we explored what we mean by ’Evidence-Based Investing’. The Executive Summary Being: Grounding your investment strategy in rational methodology increases the likelihood of attractive performance and strengthens your ability to stay on course toward your financial goals, as we:
- Assess an existing ‘factors’ capacity to offer expected returns and diversification benefits.
- Understand why such ‘factors’ exist so we can most effectively apply them.
- Explore additional ‘factors’ that may (or may not) complement our structured approach.
Assessing the Evidence (So Far): An accumulation of studies dating back to the 1950s through today has identified Three Stock Market Factors that have formed the backbone for evidence-based portfolio construction over the long-run:
- The Equity Premium – Stocks (equities) have returned more than bonds (fixed income), as we described in “What Drives Market Returns?”*
- The Small-Cap Premium – Small-Company stocks have returned more than Large-Company stocks.*
- The Value Premium – Value companies (with lower ratios between their stock price and various business metrics such as book value, company earnings, sales and/or cash flow) have returned more than Growth companies (with higher such ratios). Value stocks are stocks that, based on the empirical evidence, appear to be either undervalued or more fairly valued by the market, compared with their growth stock counterparts.*
When you hear financial professionals talking about “three-factor modeling” for equities (Stocks), the foregoing is the trifecta of factors involved.
Similarly, academic inquiry has identified two primary factors driving fixed income (Bond) returns:
- The Term Premium – Bonds with distant maturities or due dates have returned more than bonds that come due quickly.*
- The Credit Premium – Bonds with lower credit ratings (less than Investment Grade, but not necessarily “junk” bonds) have returned more than bonds with higher credit ratings (such as U.S. Treasury Bonds).*
Understanding the Evidence: Scholars and practitioners alike strive to determine not only that various return factors exist, but why they exist. This helps us determine whether a factor is likely to persist (so we can build it into a long-term portfolio) or is more likely to disappear upon discovery.
Explanations for why persistent factors linger generally fall into two broad categories:
- Risk-Related and
A Tale of Risks and Expected Rewards: It appears that persistent premium returns are often explained by accepting market risk – the kind that cannot be diversified away – in exchange for expected reward.
For example, it’s presumed that value stocks are riskier than growth stocks. In “Do Value Stocks Outperform Growth Stocks?” CBS MoneyWatch columnist Larry Swedroe explains: “Value companies are typically more leveraged (have higher debt-to-equity ratios); have higher operating leverage (making them more susceptible to recessions); have higher volatility of dividends; and have more ‘irreversible’ capital (more difficulty cutting expenses during recessions).”
A Tale of Behavioral Instincts: There may also be behavioral foibles at play. That is, our basic-survival instincts often play against otherwise well-reasoned financial decisions. As such, the market may favor those who are better at overcoming their impulsive, often damaging gut reactions to breaking news. Once we complete our exploration of market return factors, we’ll explore the fascinating field of behavioral finance in more detail, as this ‘human factor’ contributes significantly to your ultimate success or failure as an Evidence-Based Investor.
Our Take-Home: Factors that figure into market returns may be a result of taking on added risk, avoiding the self-inflicted wounds of behavioral temptations, or (probably) a mix of both. Regardless, existing and unfolding inquiry on market return factors continues to hone our strategies for most effectively capturing expected returns that enable us to ‘Purposefully’ assist our clients with achieving their uniquely personal goals. The same inquiry continues to identify other promising factors that may help us augment our already strong, Evidence-Based approach to investing. We will turn to these next.
So, trusting you won’t be ‘Shorting Venezuelan Bovine Futures’ while ‘Going Long Russian Rubles’ anytime in the near future – which even our Buddy has foregone – we remain
Warburton Capital Management