It seems an appropriate topic to discuss at this point in time. With equity indices around the world at all-time highs it would be easy to think markets have never been so expensive. Many of our readership will be aware of the capital asset pricing model (CAPM), that outlines the two main factors that determine an investor’s expected returns: the time value of money and their risk appetite. This is the trade-off investors should expect in efficient markets.
Given current returns on cash have been low compared to history, it is not farfetched to think that investors have been adequately compensated for investing in equity markets. The best rate before tax on an easy access savings account is currently about 1.15%, the yield on a 10 year UK government bond is actually lower at 1.07% and the average yield on the FTSE 350 is 3.5%*. Given the higher income yield for taking on a greater level of risk, it goes some way to explaining why equity markets remain buoyant. It also shows there is no reward from investing in UK government bonds considering the added risk.
The CAPM model outlines some of the reasons why in efficient markets, what return should be achieved for a given level of risk. Fama and French (FF) attempted to better explain this concept. Their research identified two additional factors to explain excess returns compared to the expected market return. They found that value stocks historically outperformed growth stocks, identifying value by a low price to underlying value of the firm’s assets (Book Value). They also found that small capitalised stocks historically outperform large capitalised stocks, with an excess return for taking on the higher risk from the costs associated with financing a smaller business. The FF model maintains the assumption that taking on higher risk requires a higher return. Adding small sized and low value stock factors into a portfolio raises the individual risks and, with it, the required return for a portfolio, but as a combination of all three factors this may not necessarily raise the portfolio risk.
By combining small value factors that differ from market risks, some level of diversification is achieved. By incorporating the FF’s two additional factors, it can explain 90% of a diversified portfolio’s returns versus 70% from the CAPM model alone. By understanding this concept investors can make a judgement about a manager’s strategy and are better placed to identify manager outperformance (alpha). Simply, investors must be compensated with higher returns compared to the market for entering a value based or small capitalised fund strategy.
Although a largely theoretical concept it does outline several important considerations for investors. Market risk, Company Size and Valuation explain the majority of investor returns based on historic data. This means that buying a passive index fund that contains all market constituents is likely to underperform a managed portfolio which incorporates an element of small capitalised and value orientated stock investments. It also provides a cautionary tale that purely picking a fund that achieved the best historic return does not mean it is the best candidate. It is as much about the level of risk taken to arrive at that return that determines the most optimum selection. With markets at all-time highs, it is even more important to identify the fund manager that adds value through alpha rather than those that would take on more risk just to outperform the market. Funds that do not take the optimum approach are likely to be hit the hardest in volatile markets.
*All data is correct at the time of writing (4 April 2017)