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question:Long-Only Value Investing: Size Doesn’t Matter! Please explain like I am a layperson: By Wesley Gray, PhD | Published On: June 15th, 2023 Categories: Research Insights, Factor Investing, Key Research, Value Investing Research Many factor investors are familiar with “small-cap value investing,” which is a reasonable allocation for long-term investors who can tolerate a lot of volatility. Why are there so many small-cap value investors? Small-cap value investors have been told that the value premium is higher, on average, in small stocks versus larger stocks. Unfortunately, this is not true if you are a long-only value investor.(1). Our own Jack Vogel recently published a paper called “Long-Only Value Investing: Does Size Matter?” which makes this point clear.(2) The fact large-cap value and small-cap value stocks earn similar returns may be shocking for investors who have been sold the idea that value investors have to invest in small-caps to capture the value premium. But we need to remember that data/evidence should drive decisions, not stories. A simple example will highlight the fragility of the result that small-cap value beats large-cap value. First, let’s look at a chart of equal-weight long-only portfolios sorted on book/market via the data from the paper.(3) The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged and do not reflect management or trading fees, and one cannot invest directly in an index. Key Result: Large-cap value stocks outperform small-cap value stocks on an absolute and risk-adjusted basis. Here are the detailed stats: The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged and do not reflect management or trading fees, and one cannot invest directly in an index. Wait a second! That can’t be true. All the research suggests value works better in small-caps. I tested it on Ken French’s website! Don’t worry, the date on Ken Fench’s website is correct, but the portfolios from that website are crafted in a different way… Below we look at the typical small-cap value and large-cap value chart, which compares value-weighted(4) large-cap and small-cap portfolios and looks at tercile sorts, not decile sorts. The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged and do not reflect management or trading fees, and one cannot invest directly in an index. Eureka! We can replicate the result generated from data on Ken French’s website. Here are the statistics: The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged and do not reflect management or trading fees, and one cannot invest directly in an index. What is the point of the exercise above? The point is that evidence-based investors want to invest on robust and reliable fact patterns, not results that can change dramatically via cherry-picked portfolio formations. Why are the portfolios above fragile? Simple: Size doesn’t matter when it comes to value investing. Valuation does. Let’s go for an intuitive example with low complexity. For example, if you can buy a portfolio with an average P/E of 5x and a market cap of 10B, this will, using historical datasets, outperform a portfolio with an average P/E of 8x and a market cap of 500mm. Why? Size doesn’t drive expected returns — valuation does.(5)(6) [/ref] The reason this result may be surprising to readers is that size and value investing have never really been explored in a simple-to-understand way for non-PhDs. Fortunately, Jack’s latest research paper solves this problem! Let’s dive into what I feel are the key points of Jack’s published paper. Point #1: Long-Only Value Investing is Different than Long-Short Value Investing As many readers know, academic research papers often study so-called zero investment long/short factor portfolios. But in the real world, most investors often don’t invest in these portfolio structures (outside of AQR and a few other providers)–they invest in long-only portfolios. Why does Jack bring this up? Well, many investors cite research that speaks to long/short portfolio analysis, and this analysis may not apply to their long-only portfolio decisions. This topic is addressed in more depth here. Bottom line: if you are investing in long-only factor portfolios, focus on research that studies long-only factor portfolios, not long-short factors. Point #2: Portfolio Formation Matters…a lot. At the outset of this post, we made it clear that how one forms a portfolio can significantly drive results. By manipulating several decision points — 1) equal-weight vs. value-weight and 2) decile vs. tercile sorts — we can tell a story that large-cap value dominates small-cap value, or we can tell a story that small-cap value dominates large-cap value (the story most often told). But the important thing to note is these are both “stories” because they cherry-pick aspects of the data to highlight a particular argument. Jack’s paper cuts through the stories told on size and value investing and conducts a robust study that looks at long-only portfolios with various valuation metrics, various portfolio formation techniques, and various geographies and sample time periods. Throughout the paper, Jack breaks the top 3000 largest companies into the biggest 1000 firms (“large caps”) and the next largest 2000 firms (“small caps”). This breakdown is done to reflect how practitioners think about the marketplace and should be more applicable to long-only investors than research that uses NYSE percentile breakpoints.(7) The breakdown of what percentage of the market resides in these respective buckets is in the chart below: In general, large caps represent the vast majority of the investment universe, but this varies over time. Important to note, that mega-caps, at times, can represent a large portion of a portfolio if the portfolio has “value-weight” construction versus equal-weight construction. Take a simple example. Let’s say you sort the universe of stocks on P/E and find Apple in your portfolio and then stock X, which has a 100 billion market cap — not exactly “small”. Apple, which currently(8) has ~ 7.5% weight in the entire S&P 500, and a market cap of nearly 3 trillion, if dumped into a so-called “value portfolio” with two stocks, would represent 97% of the portfolio (3T / 3.1 Trillion). Is this value-weighted portfolio really representative of the value factor? Or is it representative of Apple? In order to avoid the noise tied to market-cap, or “value-weighted” portfolios, Jack focuses his results on how equal-weight large-cap portfolios compare to both value-weighted and equal-weighted small-cap portfolios. But before one claims that equal-weight large-cap portfolios are the same as small-cap portfolios, let’s look at the median ratio of the market caps of these portfolios over time: The equal-weight large-cap portfolios are always at least 10x as large as the different small-cap portfolios. To be clear, equal-weighting large-cap portfolios isn’t equalizing the size characteristic, it is simply eliminating hidden noise in market-cap-weighted large-cap portfolios. Point #3: Surprise! Large-Cap and Small-Cap Value Investing Earn Similar Returns Jack slices and dices the results in a variety of ways, but here are the summary results for the US market: The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged and do not reflect management or trading fees, and one cannot invest directly in an index. Summary: no difference in average returns between large-cap and small-cap portfolios. What about international markets? The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged and do not reflect management or trading fees, and one cannot invest directly in an index. Summary: no difference in average returns between large-cap and small-cap portfolios. There you have it. The small-cap sacred cow has been slaughtered. Conclusions We highly recommend you study this paper in-depth because there is a high chance that the results will be shocking to many. One can only publish so many tables and results in a peer-reviewed journal, but you can be sure that every stone was turned when Jack conducted this research. Of course, please share your replication results and questions with our team. Our goal is to bring transparency to the long-only value investing debate. I hope you enjoy reading this paper as much as I did. I really learned a lot, and the analysis gave me more confidence in investing in mid and large-cap value strategies, as opposed to only investing in small-cap value, which is also interesting, but not more interesting than value investing, in general. Finally, if you love small-cap investing, you should really like equal-weight large-cap value investing — similar expected returns with almost no holdings overlap (which may provide diversification opportunities). One should also consider that all of the results in this paper are on hypothetical portfolios that assume no trading costs. If we believe that trading costs are higher in smaller and more illiquid stocks (Exhibit 4 in the paper highlights that large-cap value portfolios are 10x+ more liquid than small-cap value portfolios), we’d expect transaction costs to degrade small-cap portfolios relatively more than large-cap portfolios.
answer:This article by Wesley Gray, PhD, delves into the topic of value investing and brings into question the commonly held belief that investing in small-cap value stocks outperforms investing in large-cap value stocks. Here's a simplified breakdown of his key points: 1. **Value Investing**: - **Value investing** is a strategy where investors look for stocks that are undervalued by the market. These are stocks that are believed to be trading for less than their intrinsic or book value. 2. **Small-Cap vs. Large-Cap Misconception**: - There's a popular idea that small-cap value stocks (companies with smaller market capitalization generally between 300 million to 2 billion) tend to outperform large-cap value stocks (companies with larger market capitalization, typically more than 10 billion). This is what Gray's article is challenging. 3. **New Research by Jack Vogel**: - Gray references a research paper by Jack Vogel which suggests that there isn't a significant difference in the long-term performance between small-cap value stocks and large-cap value stocks. 4. **Important Points from the Research**: - **Long-Only Investing**: Vogel's paper focuses on 'long-only' investing, which means buying and holding stocks, as opposed to 'long-short' investing, which involves buying undervalued stocks and selling overvalued stocks. - **Portfolio Formation**: The way portfolios are constructed can greatly influence the results. Portfolios can be value-weighted (where bigger companies have a larger weight) or equal-weighted (where each company has the same weight). - **Comparison Results**: After analyzing various metrics, geographies, and time periods, Vogel's paper concludes that large-cap value stocks and small-cap value stocks have similar average returns. 5. **Implications for Investors**: - This research shakes the widely accepted narrative and suggests that investors might not need to focus on small-caps to capture the value premium. It implies that value exists across all sizes of companies and what really drives returns is how undervalued the stocks are relative to their true worth (valuation). - Investors should consider mid and large-cap value strategies, not only small-cap, since the expected returns may not be significantly different and could offer better liquidity (ease of buying and selling) and lower trading costs. - Gray suggests that there could also be diversification benefits since there's little overlap between the holdings in large-cap and small-cap value portfolios. 6. **Critique of Conventional Wisdom**: - The article presents a critical look at the established wisdom within the investing community, advocating for decisions based on robust data rather than anecdotal evidence or historical trends that might not hold true under different portfolio formation methods. 7. **Conclusion and Recommendation**: - The conclusion is that investors should not be swayed by the past popularity of small-cap value investing and should take a more evidence-based approach by considering the findings of this new research. Gray encourages readers to study the paper in-depth and to consider the results when making their own investment decisions. He also notes the importance of accounting for potential trading costs, which tend to be higher for small-cap stocks due to their lower liquidity compared to large-caps.
question:Does small caps include the universe of micro caps?
answer:In the hierarchy of company sizes based on market capitalization, small caps and micro caps represent different categories, though they are often discussed together in the context of smaller companies in the market. - **Micro Caps**: These are companies with a market capitalization typically between 50 million and 300 million. They are considered smaller than small caps and are often more volatile and less liquid. Micro caps can be riskier investments because they are less established and may not have a proven track record. - **Small Caps**: These companies have a market capitalization typically ranging from 300 million to 2 billion. They are larger and generally considered to be more established than micro caps but are still smaller than mid-cap and large-cap companies. So, to answer your question, small caps do not include micro caps; they are separate categories. However, both fall under the broader umbrella of smaller company stocks when investors or analysts discuss market segments based on size. Sometimes investment funds or indices that target small-cap stocks might also include micro-cap stocks, but usually, they are considered distinct segments with different risk and return profiles.
question:Would investing in a tax efficient ETF (which is providing tax alpha) that focuses on large and mid caps usually have higher returns than trading microcaps where I need to constantly buy and sell (weekly rebalance) and face higher trading costs due to lower liquidity?
answer:As an AI, I cannot predict future returns or provide personalized investment advice, but I can explain the concepts involved, which might help you understand the implications of each investment choice. **Tax-Efficient ETFs (Large and Mid Caps)**: - **Tax Efficiency**: ETFs are generally known for being tax-efficient because they often have lower turnover rates compared to actively managed funds. This means they generate fewer capital gains distributions, which can be taxable events for investors. - **Large and Mid Caps**: These companies tend to be more stable and have more predictable revenue streams compared to micro caps. They also tend to be more liquid, which can translate into lower trading costs. - **Tax Alpha**: This is the added value that an investment strategy brings through its ability to minimize tax liabilities. For long-term investors, tax alpha can significantly impact after-tax returns. - **Potential for Returns**: Large and mid-cap companies might have slower growth potential in comparison to micro caps, but they generally offer lower risk. The lower volatility could potentially lead to more consistent, though possibly lower, returns compared to micro caps over time. **Trading Microcaps (Weekly Rebalance)**: - **Trading Costs**: Micro caps often incur higher trading costs due to lower liquidity. Frequent trading, like weekly rebalancing, can lead to significant transaction costs, which will reduce net returns. - **Volatility and Risk**: Micro caps are more volatile and riskier. While this can result in higher returns if carefully selected, it also increases the chance of large losses. This risk is compounded when trading frequently. - **Market Efficiency**: Micro caps might be less efficiently priced due to less analyst coverage and lower investor interest, potentially offering opportunities for higher gains if undervalued companies are identified. However, it takes skill, time, and resources to consistently identify these opportunities. - **Tax Implications**: Frequent trading generates short-term capital gains, which are taxed at higher ordinary income tax rates, compared to long-term capital gains. This can eat into the profits significantly, especially if you are in a high tax bracket. **Comparing Both Options**: The decision between investing in a tax-efficient ETF that focuses on large and mid-cap stocks versus frequently trading micro caps depends on several factors, including your investment goals, risk tolerance, time horizon, knowledge of the market, and personal tax situation. The tax-efficient ETF might have lower expected returns compared to successfully trading undervalued micro caps but will likely offer a more stable growth trajectory with fewer downsides related to taxes and transaction costs. Conversely, trading in micro caps could potentially offer higher returns but comes with much higher risk, costs, and tax inefficiencies. For most individual investors, especially those who do not have the time or expertise to engage in high-frequency trading of micro caps, the tax-efficient ETF might be a more suitable option due to its lower risk profile and tax advantages. However, every investor's situation is unique, and it's essential to consider personal circumstances before making any investment decisions. Consulting a financial advisor for personalized advice is always recommended.