There are certain beliefs widely accepted among financial academics and practitioners as truths:
- Risk and return are related
- Diversification is good
- Markets are unpredictable in the short term
Beyond that, most issues remain unproven and hotly contested. The most important - and most contentious - issue for investment managers is whether or not markets are efficient. There is no doubt that inefficiencies happen (such as bubbles and flash-crashes), and there is little doubt that investors exhibit behaviors that are irrational, as is well documented (see behavioral finance).
However, there is a big difference between knowing that the above events happen, and being able to consistently profit from them. In fact, countless studies on the subject all show that managers cannot consistently outperform through active security selection and that returns are randomly distributed around a mean of market-minus-fees. What this suggests is that returns display the characteristics of being a function of luck, and that there is no discernible evidence that anyone can display consistent skill. In other words, for practicality sake, markets are effectively efficient.
This fact has profound implications for money management. If managers cannot be expected to outperform the markets, why pay management fees to them in hopes of doing so? The answer of course, is that you shouldn't.
However, that does not mean that portfolio management is pointless. Instead of trying to out-smart the markets in a vain attempt to beat them, we can apply science to the process and actually do so (well, not outperform them exactly, but gain exposures that maximize the risk-return tradeoff).
The Three Factor Model
Most of the practiced science of finance is based on the Capital Asset Pricing Model (CAPM). In overly simplistic terms, it states that the return on a security or portfolio is equal to alpha (which is the incremental return generated by superior security selection, i.e. active management) plus beta times the market return (where beta is the ratio of the volatility of the security or portfolio vs. the volatility of the market). Since alpha is assumed to be zero (if all investors in total are the market, they must, in the aggregate, equal the market - before fees and transaction costs), and the return on the market is a given, this formula boils down to beta, or the volatility of the security or portfolio being considered relative to market volatility. This is a one-factor model.
Unfortunately, it only explains approximately 70% of the price movement of the dependent variable. Eugene Fama and Kenneth French have built on the principal of CAPM with their three-factor model. They have demonstrated that two other variables also help explain returns: size and book-to-market, which is really a measure of the health of a company. Together, with beta, these three factors can explain more than 90% of returns.
Intuitively, these factors make sense - smaller companies are generally perceived to be riskier than larger companies and less healthy companies (commonly referred to as value stocks) should be riskier than healthy companies (or growth stocks).
At least it makes sense that they are riskier, but why does that imply that they should have a higher expected return? First, remember that risk and return are related. But more specifically, it is a function of the cost of capital. The riskier a venture, or loan, or security, the higher its cost of capital is - investors demand a higher expected return for taking more risk. (for more on this, read The Cocktail Party Fallacy, by Eugene Fama Jr.)
This has significant implications for the investor. If small cap stocks and value stocks have a higher expected return than their respective counterparts, why not invest in them? The catch of course, is that they come with the higher volatility - they are riskier. But these are risks that you get paid to take. So doesn't it make sense to reduce other sources of risk so that you can accept these higher risk levels?
That is in fact exactly what we do. By controlling the amount of volatility from fixed income investments, and controlling risks that don't pay, such as currency risk and active management, we can increase exposure to these factors and therefore increase expected return without increasing the risk level of the portfolio (in fact, often reducing it). That is what we call spending risk dollars wisely. Also, small companies and value companies actually display less correlation with other small and value stocks geographically, than large growth stocks do. This means that there is a greater risk-dampening benefit from diversification than an investor of large growth stocks would receive. Therefore, total portfolio risk is reduced, despite the exposure to higher expected returns.
What this all means is that we can manage your portfolio, tilting your exposures towards value and small cap sectors and away from large growth stocks, thereby generating higher than market returns, while simultaneously structuring the portfolio to garner greater diversification benefits. The result being increased returns without increased overall risk, which is of course what we all want. And most importantly, it is executable, repeatable, cost-effective, and no one has to try and out-smart anyone else!