Efficient Frontier
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William J. Bernstein

The Changing Landscape of Factor Investing

The 30-year waltz of speculative excess has taken yet another pass in front of the band as a new generation of investors forgot that asset value is simply discounted income. It really was different this time, with a spasm of financial hysteria worthy of Charles Mackay's Extraordinary Popular Delusions and the Madness of Crowds (published 1841). However, Mackay manufactured out of whole cloth most of the more outlandish "bubble companies" of the annus mirabilus 1720, including that all-time favorite enterprise "for carrying on and undertaking of great advantage but no one to know what it is." The 1990s actually saw whole flocks of these improbable beasts flash across the landscape, mesmerizing the credulous and astonishing the sane.

Iíll admit it. I was thoroughly dissociated from the zeitgeist. I couldnít even figure out what part of speech Yahoo! represented. Was it an interjection, reflecting the ebullience of the era, or merely a noun, describing the companyís shareholders?

But one thing of possible import did change, which seems to have gone unnoticed thus faróthe relationship among the volatility of three returns factors: the market, size, and value. (To review, these are, respectively, the return of the market minus that of T-bills, the return of small stocks minus that of large stocks, and the return of value stocks minus that of growth stocks.) Consider now their returns in February and March of 2000:




February 2000




March 2000




Pretty wild, eh? Stranger still, in the free-fall occurring the year after this crazy sequence of events, one of the sacred rules of asset-class investing was shattered: When stocks fall out of bed, small stocks break their legs. This time, a wrathful bear uniquely decided to spare the little guys. As you can see from the below table, in each of the four major bear markets in this century, small stocks (represented by the CRSP 9-10 Index) did much worse than large stocks. Not so, however, during the most recent smashup:

S&P 500

CRSP 9-10

September 1929-June 1932



March 1937-March 1938



June 1969-June 1970



January 1973-December 1974



January 2000-March 2001



Finally, take a look at this plot of trailing 24-month standard deviations of the three factors since 1945:

For the first time, the small and value factors have become more volatile than the market factor. A single swallow does not a spring make, and rolling standard deviations are particularly treacherous; but itís possible that we are on the cusp of a new regime where the small and value factors may have both higher risks and higher returns, possibly as high as the market factor itself. (For the record, from 1945 to 1999 the returns for the market, size, and value factors were 7.85%, 0.73%, and 3.66%, respectively.)

Why might this be so? First off, the market-factor return, better known as the equity risk premium, is sure to be lower than that of the past. Most likely it will be in the range of 4%, by virtue of the Gordon Equation, which stipulates that long-term stock returns are the same as the average dividend yield plus the dividend growth rate.

Size and value are another story. Why have they become more volatile? Because for the first time, portfolio managers are actively trading them. Twenty years ago, or even ten, it would never have occurred to a manager to systematically shift his entire portfolio up or down along the size or value axis. And had he wanted to, it would not have been easily managed. Now, such decisions are routinely executed at the institutional level. Consequently, the returns of these two factors are much less stable. With increased volatility should come increased return.

Over the past two years, the volatility of the size and value factors hit most asset-class-based investors with the force of a two-by-four. The next few years will tell us whether this was a flash in the pan or a major shift in the investment risk-return paradigm.

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