The Power of Economic Science 2012
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Transcript of The Power of Economic Science 2012
Rebalanced annually. Barclays Capital data provided by Barclays Bank PLC. The S&P data are provided by Standard & Poor’s Index Services Group. The Merrill Lynch Indices are used with permission; copyright 2012 Merrill Lynch, Pierce, Fenner & Smith Incorporated; all rights reserved. Dimensional Index data compiled by Dimensional. Emerging Markets Blended Index consists of 50% Fama/French Emerging Markets Index, 25% Fama/French Emerging Markets Small Cap Index, and 25% Fama/French Emerging Markets Value Index. Fama/French Emerging Markets, Fama/French Emerging Markets Value and Fama/French Emerging Markets Small Cap Index weightings allocated evenly between Dimensional International Small Cap Index and Fama/French International Value Index prior to January 1989 data inception. Dimensional International Small Cap Value Index weighting allocated to International Small Cap Index prior to July 1981 data inception. International Value weighting allocated evenly between International Small Cap and MSCI World ex USA Index prior to January 1975 data inception. Indexes are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Not to be construed as investment advice. Returns of model portfolios are based on back-tested model allocation mixes designed with the benefit of hindsight and do not represent actual investment performance. See cover page for additional information.
CP1920.8
AnnualizedCompound
Return
Annualized StandardDeviation
Model Portfolio 1 9.34% 11.14%
Model Portfolio 2 8.65% 10.27%
Model Portfolio 3 9.46% 11.95%
Model Portfolio 4 10.33% 11.94%
Model Portfolio 5 11.15% 11.39%
Barclays US Govt./Credit
Bond Index
S&P 500 Index
BofAMerrill Lynch
One-Year US Treasury
Note Index
US Small
Cap Index
US Large Value Index
Targeted Value Index
Intl. LargeIndex
Intl.SmallIndex
Intl. Large ValueIndex
Intl.Small ValueIndex
Emerging Markets Blended
Index
Model Portfolio 1 40% 60%
Model Portfolio 2 60% 40%
Model Portfolio 3 30% 40% 30%
Model Portfolio 4 15% 40% 15% 15% 15%
Model Portfolio 5 7.5% 40% 7.5% 7.5% 7.5% 6% 6% 6% 6% 6%
Merrill Lynch One-Year US Treasury Note Index
S&P 500 Index
US Small Cap Index
US Large Value Index
Targeted Value Index
International Large Index
International Small Index
International Large Value Index
International Small Value Index
Emerging Markets Blended Index
A Fully Diversified PortfolioQuarterly: 1973-2011Model Portfolio 5
In US dollars. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. US value and growth index data (ex utilities) provided by Fama/French. The S&P data are provided by Standard & Poor’s Index Services Group. CRSP data provided by the Center for Research in Security Prices, University of Chicago. International Value data provided by Fama/French from Bloomberg and MSCI securities data. International Small data compiled by Dimensional from Bloomberg, StyleResearch, London Business School, and Nomura Securities data. MSCI EAFE Index is net of foreign withholding taxes on dividends; copyright MSCI 2012, all rights reserved. Emerging markets index data simulated by Fama/French from countries in the IFC Investable Universe; simulations are free-float weighted both within each country and across all countries.
Indexes are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio.Past performance is not a guarantee of future results. Values change frequently and past performance may not be repeated. There is always the risk that an investor may lose money. Small company risk: Securities of small firms are often less liquid than those of large companies. As a result, small company stocks may fluctuate relatively more in price. Emerging markets risk: Numerous emerging countries have experienced serious, and potentially continuing, economic and political problems. Stock markets in many emerging countries are relatively small, expensive, and risky. Foreigners are often limited in their ability to invest in, and withdraw assets from, these markets. Additional restrictions may be imposed under other conditions. Foreign securities and currencies risk: Foreign securities prices may decline or fluctuate because of: (a) economic or political actions of foreign governments, and/or (b) less regulated or liquid securities markets. Investors holding these securities are also exposed to foreign currency risk (the possibility that foreign currency will fluctuate in value against the US dollar).
Size and Value Effects Are Strong around the WorldAnnual Index Data
US Large Value
S&P 500
US Large
Growth
US Small Value
CRSP 6-10
US Small
GrowthIntl.
ValueIntl.
SmallMSCI EAFE
Intl. Growth
Emg. Markets
Value
Emg. Markets
Small
Emg. Markets “Market”
Emg. Markets Growth
US Large Capitalization Stocks
1927–2011
US Small Capitalization Stocks
1927–2011
Non-US Developed Markets Stocks
1975–2011
Emerging Markets Stocks
1989–2011
13.63 11.77 11.29 18.82 15.72 13.74 17.44 18.23 12.98 10.74 22.86 20.00 17.77 15.63
27.10 20.41 21.81 35.07 30.84 33.90 24.81 28.32 22.37 22.07 42.31 40.86 36.47 34.77
Average Return (%)
Standard Deviation (%)
Annualized Compound Returns (%)
RR1220.9
RR1260.4
Structure Determines Performance
• The vast majority of the variation in returns is
due to risk factor exposure.
• After fees, traditional management typically reduces returns.
sensitivity to market
[market return minus T-bills]
sensitivity to size
[small stocksminus big stocks]
sensitivity to BtM
[value stocksminus growth]
randomerrore(t)
++ + +=average expected return
[minus T-bills]
average excess return
THE MODEL TELLS THE DIFFERENCE BETWEEN INVESTING AND SPECULATING
Priced Risk• Positive expected return.• Systematic.• Economic.• Long-term.• Investing.
Unpriced Risk• Noise.• Random.• Short-term.• Speculating.
Structured Exposure to Factors.
Unexplained Variation
• Market.• Size.• Value/Growth.
Five Factors Help Determine Expected ReturnAnnual Average Returns1927–2011
Equity factors provided by Fama/French. Maturity factor and credit factor data (1927–1972) provided by © Stocks, Bonds, Bills, and Inflation Yearbook©, Ibbotson Associates, Chicago (annually updated work by Roger G. Ibbotson and Rex A. Sinquefield). Credit factor data (1973–present) provided by Barclays Bank PLC. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio.
7.94%
3.66%
4.73%
2.51%
0.63%
Market Factor
All Equity Universe
minus T-Bills
Size Factor
Small Stocks minus
Large Stocks
BtM Factor
High BtMminus
Low BtM
Maturity Factor
LT Govt.minus
T-Bills
Credit Factor
LT Corp.minus
LT Govt.
RR1270.3
Periods based on rolling annualized returns. 727 total 25-year periods. 787 total 20-year periods. 847 total 15-year periods. 895 total 10-year periods. 967 total 5-year periods.Performance based on Fama/French Research Factors. Securities of small companies are often less liquid than those of large companies. As a result, small company stocks may fluctuate relatively more in price. Mutual funds distributed by DFA Securities LLC.
The Risk Dimensions DeliveredJuly1926–December 2011
Value beat growth 100% of the time.
Value beat growth 100% of the time.
Value beat growth 99% of the time.
Value beat growth 96% of the time.
Value beat growth 86% of the time.
US Value vs. US GrowthOVERLAPPING PERIODS
Value beat growth 100% of the time.
Value beat growth 100% of the time.
Value beat growth 95% of the time.
Value beat growth 91% of the time.
Value beat growth 81% of the time.
Small beat large 96% of the time.
Small beat large 83% of the time.
Small beat large 78% of the time.
Small beat large 68% of the time.
Small beat large 60% of the time.
US Small vs. US Large
Small beat large 97% of the time.
Small beat large 88% of the time.
Small beat large 82% of the time.
Small beat large 75% of the time.
Small beat large 59% of the time.
RR1271.5
Based on rolling annualized returns. Rolling multi-year periods overlap and are not independent. This statistical dependence must be considered when assessing the reliability of long-horizon return differences. International Value vs. International Growth data: 145 overlapping 25-year periods. 205 overlapping 20-year periods. 265 overlapping 15-year periods. 325 overlapping 10-year periods. 385 overlapping 5-year periods. International Small vs. International Large data: 205 overlapping 25-year periods. 265 overlapping 20-year periods. 325 overlapping 15-year periods. 385 overlapping 10-year periods. 445 overlapping 5-year periods. International Value and Growth data provided by Fama/French from Bloomberg and MSCI securities data. International Small data compiled by Dimensional from Bloomberg, StyleResearch, London Business School, and Nomura Securities data. International Large is MSCI World ex USA Index gross of foreign withholding taxes on dividends; copyright MSCI 2012, all rights reserved.
The Risk Dimensions Delivered
Small beat large 100% of the time.
Small beat large 100% of the time.
Small beat large 84% of the time.
Small beat large 76% of the time.
Small beat large 75% of the time.
International Small vs. International Large
Small beat large 100% of the time.
Small beat large 97% of the time.
Small beat large 83% of the time.
Small beat large 79% of the time.
Small beat large 79% of the time.
Value beat growth 100% of the time.
Value beat growth 100% of the time.
Value beat growth 100% of the time.
Value beat growth 100% of the time.
Value beat growth 98% of the time.
International Value vs. International GrowthOVERLAPPING PERIODS
Value beat growth 100% of the time.
Value beat growth 100% of the time.
Value beat growth 100% of the time.
Value beat growth 100% of the time.
Value beat growth 98% of the time.
January 1975–December 2011 January 1970–December 2011
RR1271.5
• Equity Market(complete value-weighted universe of stocks)Stocks tend to have higher expected returns than fixed income over time.
• Company Size(measured by market capitalization)Small company stocks tend to have higher expected returns than large company stocks over time.
• Company Price(measured by ratio of company book value to market equity)Lower-priced “value” stocks tend to have higher expected returns than higher-priced “growth” stocks over time.
Eugene F. Fama and Kenneth R. French, “The Cross-Section of Expected Stock Returns,” Journal of Finance 47, no. 2 (June 1992): 427-65.Eugene F. Fama and Kenneth R. French are consultants for Dimensional Fund Advisors. This page contains the opinions of Eugene F. Fama and Kenneth R. French but not necessarily of Dimensional Fund Advisors or DFA Securities LLC, and does not represent a recommendation of any particular security, strategy, or investment product. The opinions expressed are subject to change without notice. This material is distributed for educational purposes only and should not be considered investment advice or an offer of any security for sale. Dimensional Fund Advisors (“Dimensional”) is an investment advisor registered with the Securities and Exchange Commission. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products or services described. ©2012 by Dimensional Fund Advisors. All rights reserved.
Value
Large
Small
Growth
Increased RiskExposure andExpected Return
TotalStockMarket
Decreased Risk Exposure and
Expected Return
Three Dimensions of Stock Returns around the World
RR1274.3
Risk and Return Are Related
Mutual Fund Expenses
“After costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar for any time period.”
—William F. Sharpe, 1990 Nobel Laureate
William F. Sharpe, “The Arithmetic of Active Management,” Financial Analysts Journal 47, no. 1 (January/February 1991): 7-9.Mutual fund expense ratios as of April 9, 2010. Asset weighting based on net assets as of December 31, 2008. Data provided by Morningstar, Inc.Passive funds are those coded by Morningstar as Index Funds.
Average of All Funds
Weighted Average, Based on Fund Assets
Active Passive
Domestic Mutual Fund Expense Ratios
Average of All Funds
Weighted Average, Based on Fund Assets
Average of All Funds
Weighted Average, Based on Fund Assets
Active Passive
Average of All Funds
Weighted Average, Based on Fund Assets
International Mutual Fund Expense Ratios
IC1420.5
Innovations in FinanceIT1610.2
1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974
The Birth of Index Funds
John McQuown,Wells Fargo Bank, 1971;Rex Sinquefield,American National Bank, 1973
Banks develop the first passive S&P 500 Index funds.
Efficient Markets Hypothesis
Eugene F. Fama,University of Chicago
Extensive research on stock price patterns.
Develops Efficient Markets Hypothesis, which asserts that prices reflect values and information accurately and quickly. It is difficult if not impossible to capture returns in excess of market returns without taking greater than market levels of risk.
Investors cannot identify superior stocks using fundamental information or price patterns.
Single-Factor Asset Pricing Risk/Return Model
William SharpeNobel Prize in Economics, 1990
Capital Asset Pricing Model: Theoretical model defines risk as volatility relative to market.
A stock’s cost of capital (the investor’s expected return) is proportional to the stock’s risk relative to the entire stock universe.
Theoretical model for evaluating the risk and expected return of securities and portfolios.
The Role of Stocks
James TobinNobel Prize in Economics, 1981
Separation Theorem:1. Form portfolio of risky assets.2. Temper risk by lending and borrowing.
Shifts focus from security selection to portfolio structure.
“Liquidity Preference as Behavior Toward Risk,” Review of Economic Studies, February 1958.
Conventional Wisdom circa 1950
“Once you attain competency, diversification is undesirable. One or two, or at most three or four, securities should be bought. Competent investors will never be satisfied beating the averages by a few small percentage points.”
Gerald M. Loeb, The Battle for Investment Survival, 1935
Analyze securities one by one. Focus on picking winners. Concentrate holdings to maximize returns.
Broad diversification is considered undesirable.
Diversification and Portfolio Risk
Harry MarkowitzNobel Prize in Economics, 1990
Diversification reduces risk.
Assets evaluated not by individual characteristics but by their effect on a portfolio. An optimal portfolio can be constructed to maximize return for a given standard deviation.
Investments and Capital Structure
Merton Miller and Franco ModiglianiNobel Prizes in Economics,1990 and 1985
Theorem relating corporate finance to returns.
A firm’s value is unrelated to its dividend policy.
Dividend policy is an unreliable guide for stock selection.
Behavior of Securities Prices
Paul Samuelson, MITNobel Prize in Economics, 1970
Market prices are the best estimates of value.
Price changes follow random patterns. Future share prices are unpredictable.
“Proof That Properly Anticipated Prices Fluctuate Randomly,” Industrial Management Review, Spring 1965.
First Major Study of Manager Performance
Michael Jensen, 1965A.G. Becker Corporation, 1968
First studies of mutual funds (Jensen) and of institutional plans (A.G. Becker Corp.) indicate active managers underperform indices.
Becker Corp. gives rise to consulting industry with creation of “Green Book” performance tables comparing results to benchmarks.
Options Pricing Model
Fischer Black, University of Chicago;Myron Scholes, University of Chicago;Robert Merton, Harvard UniversityNobel Prize in Economics, 1997
The development of the Options Pricing Model allows new ways to segment, quantify, and manage risk.
The model spurs the development of a market for alternative investments.
IT1610.2
1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Nobel Prize Recognizes Modern Finance
Economists who shaped the way we invest are recognized, emphasizing the role of science in finance.
William Sharpe for the Capital Asset Pricing Model.
Harry Markowitz for portfolio theory.
Merton Miller for work on the effect of firms’ capital structure and dividend policy on their prices.
Variable Maturity Strategy Implemented
Eugene F. Fama
With no prediction of interest rates, Eugene Fama develops a method of shifting maturities that identifies optimal positions on the fixed income yield curve.
“The Information in the Term Structure,” Journal of Financial Economics 13, no. 4 (December 1984): 509-28.
Multifactor Asset Pricing Model and Value Effect
Eugene Fama and Kenneth French,University of Chicago
Improves on the single-factor asset pricing model (CAPM).
Identifies market, size, and “value” factors in returns.
Develops the three-factor asset pricing model, an invaluable asset allocation and portfolio analysis tool.
“Common Risk Factors in the Returns on Stocks and Bonds,” Journal of Financial Economics 33, no. 1 (February 1993): 3-56.
Database of Securities Prices since 1926
Roger Ibbotson andRex Sinquefield,Stocks, Bonds, Bills, and Inflation
An extensive returns database for multiple asset classes is first developed and will become one of the most widely used investment databases.
The first extensive, empirical basis for making asset allocation decisions changes the way investors build portfolios.
A Major Plan First Commits to Indexing
New York Telephone Companyinvests $40 million in an S&P 500Index fund.
The first major plan to index.
Helps launch the era of indexed investing.
“Fund spokesmen are quick to point out you can’t buy the market averages. It’s time the public could.”
Burton G. Malkiel, A Random Walk Down Wall Street, 1973 ed.
International Size Effect
Steven L. Heston, K. Geert Rouwenhorst, and Roberto E. Wessels
Find evidence of higher average returns to small companies in twelve international markets.
“The Structure of International Stock Returns and the Integration of Capital Markets,” Journal of Empirical Finance 2, no. 3 (September 1995): 173-97.
The Size Effect
Rolf Banz, University of Chicago
Analyzed NYSE stocks,1926-1975.
Finds that, in the long term, small companies have higher expected returns than large companies and behave differently.
Integrated Equity
Eugene F. Fama and Kenneth R. French
Increasing exposure to small and value companies relative to their market weights and integrating the portfolio across the full range of securities may reduce the turnover and transaction costs normally associated with forming an asset allocation from multiple components.
“Migration,” CRSP Working Paper No. 614, Center for Research in Security Prices, University of Chicago, February 2007.
Innovations in Finance
0
2
4
6
8
10
12
14
One-Month US TreasuryBills
Six-Month US TreasuryBills
One-Year US TreasuryNotes
Five-Year US TreasuryNotes
Twenty-Year USGovernment Bonds
Evaluating the Maturity Risk/Return Tradeoff Quarterly: 1964–2011
Source: One-Month US Treasury Bills, Five-Year US Treasury Notes, and Twenty-Year (Long-Term) US Government Bonds provided by Ibbotson Associates. Six-Month US Treasury Bills provided by CRSP (1964–1977) and BofA Merrill Lynch (1978–present). One-Year US Treasury Notes provided by CRSP (1964–May 1991) and BofA Merrill Lynch (June 1991–present). Ibbotson data © Stocks, Bonds, Bills, and Inflation Yearbook™, Ibbotson Associates, Chicago (annually updated work by Roger G. Ibbotson and Rex A. Sinquefield). CRSP data provided by the Center for Research in Security Prices, University of Chicago. The Merrill Lynch Indices are used with permission; copyright 2012 Merrill Lynch, Pierce, Fenner & Smith Incorporated; all rights reserved.
Indexes are not available for direct investment. Index performance does not reflect expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Values change frequently and past performance may not be repeated. There is always the risk that an investor may lose money. Fixed income securities are subject to interest rate risk because the prices of fixed income securities tend to move in the opposite direction of interest rates. In general, fixed income securities with longer maturities are more sensitive to these price changes and may experience greater fluctuation in returns.
CP1840.8
• Not all investors define risk as standard deviation. Some investors may seek to hedge long-term liabilities using long-term bonds.
• Historically, longer-maturity instruments have higher standard deviations than shorter-maturity instruments.
Annualized Compound Returns
Annualized Standard Deviation
Maturity
One-Month US Treasury
Bills
Six-Month US Treasury
Bills
One-Year US Treasury
Notes
Five-Year US Treasury
Notes
Twenty-Year US Govt.
Bonds
Annualized Compound Return (%) 5.33 6.07 6.28 7.32 7.77
Annualized Standard Deviation (%) 1.46 1.80 2.35 6.17 11.51
CP2000.6
Copyright MSCI 2012. Unpublished. All rights reserved. This information may only be used for your internal use, may not be reproduced or redisseminated in any form and may not be used to create any financial instruments or products or any indices. This information is provided on an “as is” basis and the user of this information assumes the entire risk of any use it may make or permit to be made of this information. Neither MSCI, any of its affiliates, nor any other person involved in or related to compiling, computing or creating this information makes any express or implied warranties or representations with respect to such information or the results to be obtained by the use thereof, and MSCI, its affiliates, and each such other person hereby expressly disclaims all warranties (including, without limitation, all warranties of originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall MSCI, any of its affiliates or any other person involved in or related to compiling, computing, or creating this information have any liability for any direct, indirect, special, incidental, punitive, consequential, or any other damages (including, without limitation, lost profits) even if notified of, or if it might otherwise have anticipated, the possibility of such damages.
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