THE VALUE FACTOR CONTINUED

Tables 6-5 through 6-7 are comparisons of style returns using three index providers. FF provides the first set of returns, Frank Russell and Company provides the second, and Dimensional Fund Advisors (DFA) provides the third. The FF and DFA indexes go back to 1926, whereas the Russell indexes originate in 1979. The comparison given here uses 30 years of data from the inception of the Russell indexes.

Before discussing the results of the study, an explanation of the methodology is needed. There are large differences in stock selection methods in the FF/DFA value indexes and the Russell value indexes.

First, FF and DFA use only one fundamental ratio to separate growth from value. Specifically, FF use book-to-market as a proxy.

Russell uses a multifactor model to separate growth and value.

Second, the FF/DFA style indexes are mutually exclusive, meaning that if a stock is in one style, it is not in the other. Russell uses a graduated scale to make the transition from growth to value. If a stock in the Russell index has both value and growth characteris-tics, its market value could be divided into both segments. For example, a stock could have 60 percent of its market value attrib-uted to growth and 40 percent to value. Third, FF neutral indexes are mutually exclusive from their value and growth indexes, whereas the Russell indexes do not have a neutral or core category.

Table 6-5 compares the difference in risk and returns between large growth stocks, large value stocks, and large core holdings of both the FF large-cap indexes and the Russell large-cap indexes.

Although there are large differences in the style methodology of the two index providers, over the past 30 years the outcomes are sim-ilar using both the FF large-cap style indexes and the Russell 1000 large-cap style indexes. When both methodologies were used, the performance of large-cap value stocks was found to be higher than the performance of growth stocks, and the risk as measured by stan-dard deviation was less for value stocks than it was for growth stocks.

Table 6-6 is a similar comparison of the FF small-cap style indexes and Russell 2000 small-cap style indexes. The data reveal a significant difference between small-cap value and small-cap growth returns.

T A B L E 6-5

Comparing Large-Cap Funds, 1979–2009

FF FF FF Russell Russell

Large Large Large 1000 Russell 1000 Growth Index Value Growth 1000 Value

Annualized return 11.3 11.5 13.0 10.5 11.5 12.1

Standard deviation 16.6 15.6 16.1 17.8 15.6 14.9

The excess return of small-cap value stocks over small-cap growth stocks was greater for each index over the 30-year period.

In addition, the risk of small-cap value stocks as measured by their standard deviation was considerably less than that of small-cap growth stocks. The implication of the data is that the value pre-mium is stronger in the small-cap sector of the market than in the large-cap sector.

Table 6-7 compares the value premium across the total stock market as measured by the Russell 3000 indexes and the DFA indexes, which are similar to FF indexes. The Russell 3000 is an index of the 3,000 largest U.S. stocks, adjusted for free float. It is divided into the Russell 3000 Growth Index and the Russell 3000 Value Index using Russell methodology. The DFA Marketwide indexes are composed of all stocks on the Nasdaq and NYSE weighted by market capitalization.

Figure 6-5 illustrates the rolling 36-month correlation between the Wilshire 5000 Composite and the DFA Marketwide Value Index

T A B L E 6-6

Comparing Small-Cap Funds, 1979–2009

FF FF Russell Russell

Small FF Small 2000 Russell 2000 Growth Small Value Growth 2000 Value

Annualized return 7.9 12.8 17.2 8.8 11.3 13.3

Standard deviation 24.1 20.3 18.2 23.5 19.9 17.4

T A B L E 6-7

Comparing Total Market Indexes, 1979–2009

DFA Russell

DFA Marketwide Russell 3000

Marketwide Value 3000 Value

Annualized return 11.7 14.0 11.4 12.2

Standard deviation 15.7 16.8 15.8 14.9

described earlier. Notice the sharp decrease in correlation between value stocks and the composite index during the late 1990s. That event resulted from the rapid run-up in the valuation of large-cap growth stocks, especially technology stocks, which tended to dom-inate the Wilshire 5000 Index at the time.

Figure 6-6 is an interesting 30-year risk-and-return chart that combines the Russell 3000 Index with the Russell 3000 Value Index and the Russell 3000 Growth Index over 30 years. At the top left of the chart is the Russell 3000 Value risk and return and at the bottom right is the Russell 3000 Growth risk and return. In the center is the Russell 3000. Starting with the Russell 3000, each subsequent point on the chart adds a 10 percent position up or down in the Russell Value and Growth indexes. The hypothetical portfolios were rebal-anced annually.

Since 1979, the Russell 3000 Value Index has outperformed the Russell 3000 Growth Index by over 2 percent, and it did so with

0.0 0.5 1.0

Dec-60 Dec-65 Dec-70 Dec-75 Dec-80 Dec-85 Dec-90 Dec-95 Dec-00 Dec-05 Dec-10

F I G U R E 6-5

Total U.S. Market Index and DFA Marketwide Value 36-Month Rolling Correlations

about 5 percent less risk! Based on this knowledge, why would anyone invest in growth stocks? Because growth stocks are per-ceived to have less total risk in their earnings growth, and less risk means less return.

Value investing has had merit because value stocks have out-performed growth stocks over most periods, and they did it with what appears to be less risk. However, the markets have a way of punishing those who think there is a free lunch. Fama and French would argue that there is more risk in value stocks, and that is why the returns were higher. The risk has simply not shown itself in the standard deviation of returns.

A second and important item of interest in Figure 6-6 is the point in the middle of the chart. A portfolio of 50 percent in the Russell 3000 Growth Index and 50 percent in the Russell 3000 Value

9%

10%

11%

12%

13%

14 16 18 20 22 24

Standard deviation

Annualized return

Russell 3000 Index

100% Russell 3000 Growth 100% Russell 3000 Value Index

50% Russell 3000 Value and 50% Russell 3000 Growth indexes F I G U R E 6-6

Risk and Return Characteristics of Russell 3000 Indexes, 1979–2009

Index shows almost exactly the same risk and return as the Russell 3000 Index over the entire period. There was no benefit to holding a growth Fund and Value Fund in equal amounts. Yet, this strategy is one often recommended by investment advisors. A better strat-egy is to hold the total market and add elements such as small cap and value based on the total risk you are seeking.

SMALL-CAP VALUE AND RISK