2012 Q3 Market Update

The third quarter of 2012 saw a universal recovery from the summer doldrums of Q2. Assets classes performed well across the board as investors gained confidence that the European situation would be fixed, or at the very least, contained. The total returns for major asset classes are below.

Asset Class Representative Index











U.S. Equities S&P 500











Global Equities MSCI All Country Index











U.S. Bonds Barclays Aggregate Bond











The U.S. market has been very strong this year and is among the top performers worldwide. Although international markets are generally up as well, we still find ourselves in a position where diversification outside of large U.S. companies has diluted performance especially when compared to the “headline numbers” of the S&P 500.

Matter of Style

History, academic research, and common sense tells us that the vast majority of investment performance is determined by what we own – cash, stocks, or bonds – and in what proportion. This drives us to build portfolios, first and foremost, on the asset class level. It is on this level – the ratio between stocks and bonds – that we can adjust the primary risk and return attributes of a portfolio to best suit each client’s preferences and needs.

But within each asset class there are many more distinctions to be made. For stocks, there are choices regarding region and country, local or foreign currency, company size, and value and growth characteristics. For bonds, there are also country and currency choices, as well as decisions about issuers, tax treatment, credit ratings, yields, etc. The resulting classifications can be thought of as sub-asset classes, styles, or factors.

Some of the distinctions are meaningless, while others are quite meaningful. In fact, for stocks, two distinctions (factors) alone determine most of the differences between a given portfolio and the market in general. The first is the mix between large and small companies (small companies have historically performed better). The second is the overall value orientation of a portfolio (value has historically outperformed growth). The chart below provides evidence of these factors at work in markets around the world – over time, small beats large and value beats growth everywhere we look.

Truth be told, these factors (how much small and value relative to the market) can explain away the behavior of almost any actively managed stock portfolio, which is great news for investors like us who are looking for efficiency, consistency, and low costs. We can rest assured that a diversified basket of U.S. small cap value stocks (as an example) compiled using a set of rules will behave very much like a portfolio of U.S. small cap value stocks handpicked by a professional manager with strong conviction about every individual company he or she bought. Over time, we will have a very high probability of outperforming these professional managers because we are paying less in fees, trading costs, and taxes.

Here is a quiz. What I’ve just described is:

         a) Justification for avoiding active management

         b) The reason ETFs have become increasingly popular

         c) The mutual fund industry’s dirty little secret

         d) All of the above

The correct answer is D

But kidding aside, for these reasons we have always tilted our investment strategies towards the value and size factors, and always embraced a passive implementation. DFA mutual funds – our primary vehicle for implementing our allocation to stocks – allow us to capture the value and size factors with precision and efficiency. The chart below, which compares several U.S. DFA portfolios to their peer groups and indices, illustrates how their simple formula of focusing on the factors that matter most, while minimizing trading and keeping fees low produces industry leading results. (These results are not necessarily indicative of our clients’ actual results and may or may not include funds used in our investment models.)

In and Out of Style

The historical return advantages of the small and value factors are real (as are DFA’s ability to deliver them), but they do not materialize every month, every quarter or even every year. In fact, due to the cyclical nature of investing, there can be long-periods when these factors do not result in additional returns.

Referencing the cyclical nature of investment styles, Peter Lynch (who ran the Fidelity Magellan mutual fund in the 70s and 80s with stellar results) offered the following observation in his 1994 book Beating the Street.

“If you own (a) fund, you may find yourself stuck in a situation in which…the stocks in the fund have gone out of favor. A value fund, for instance, can be a wonderful performer for three years and awful for the next six “

He goes on to say that investors should put new money to work in the funds that have underperformed because styles go in and out of favor, and the last thing you should do is chase performance. Smart guy, Peter Lynch.

Posted by Jay Healy at 2:05 PM
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