How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

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nedsaid
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by nedsaid »

JoMoney wrote: Sun May 28, 2023 6:49 pm
nedsaid wrote: Sun May 28, 2023 6:29 pm
JoMoney wrote: Sun May 28, 2023 6:05 pm
McQ wrote: Sun May 28, 2023 5:42 pm...
The thread asks a question: what could the mutual fund investor have got if they had tried to harvest the size effect using the oldest avowedly small cap mutual funds available? ...
FWIW, I haven't seen it mentioned in this thread, but what's regarded as one of the oldest and highest returning mutual funds is the "T Rowe Price Small-Cap Stock Fund" OTCFX , I don't remember if I first read about it from something Mr. Bogle wrote, or from Jeremy Siegel, but it was one of them.
History on it goes back to mid-1956, over the past 67 years it's had something around 12.6% return annualized.
The "survivorship bias" of looking at that fund, without having other small-cap funds over time to compare to is a bit of an issue though.
Also worth pointing out that from 1982 (the first publication on purported Small-cap effect) to present, the funds return are roughly the same (actually a little less) than Vanguard's 500 fund.
So pretty much, the Small Cap effect existed until the academics published about its existence. To capture the premium, you would have had to know about this before the academics and then found a good fund to capture the premium. Most of us don't have the math skills or the access to data to have discovered this on our own. My best guess is that many professional investors suspected the Small Cap premium existed hence the rollout of these type of funds, an additional problem is that most mutual funds back then and even today come with sales loads. The T Rowe Price fund mentioned above might have had something like an 8 1/2 percent sales load and a 0.25% 12(b)1 fee, which would have taken a chunk of the premium.
I don't think professional investors give much credence to 'Efficient Market' theories like "Risk Premiums", but in The Intelligent Investor, when discussing ideas an 'enterprising' (not passive - who he suggested avoid small stocks completely) investor might look at, Benjamin Graham did discuss the "Bargain-Issue Pattern in Secondary Companies" and going over the odd valuation changes from smaller companies at times being relative bargains compared to the larger 'primary' stocks, and sometimes the pendulum swinging to overvalue them.
My best guess is that in Graham's time, there just wasn't much analysis of Small Cap stocks available. I remember that in the 1990's, my broker talked about what a big deal Red Chip Review was when it was started. It was pretty unique in its focus on Small Cap stocks. Most research services as well as
institutional analysts focused on the Large Cap area of the market, there was some research available for the larger Mid-Caps. Way back when, you would have had to do the research yourself and been your own analyst. Thus the Small Cap area of the market would have been more subject to speculation. It was harder to tell what was good and what was junk.
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by nisiprius »

nedsaid wrote: Sun May 28, 2023 10:34 am
nisiprius wrote: Sat May 27, 2023 1:15 pm
nedsaid wrote: Sat May 27, 2023 11:25 am...The screening for Quality is one reason I am a big fan of the S&P Indexes...
"Screening for quality" doesn't seem to move the needle very much on the actual quality of the portfolio.
How would the S&P 600 Small-Cap Index compare to a CRSP Small-Cap Index? The Morningstar article from a ways back mentioned specifically that a screening for companies that have earnings caused the Small-Cap premium to return with a vengeance. They used the S&P 600 Small-Cap Index as an example of this. Can't remember if they mentioned the Quality factor.
First of all, terrible confession. In the process of moving images around I accidentally compared Vanguard Large-Cap Index with itself. Here's the corrected comparison, and the Vanguard 500 Index Fund does have slightly higher quality:

Image

Second, yes, S&P 600 Small-Cap Index and the Vanguard [CRSP] Small-Cap Index do differ much more in quality.

Image

But the screening for quality did not "cause the Small-Cap premium to return with a vengeance." At least not in real life and not with actual investible funds. we already looked with that upthread. Small-cap Quality underperformed unscreened Small-Cap, and both of them underperformed Large-cap Blend.
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by McQ »

JoMoney wrote: Sat May 27, 2023 5:54 pm
Gaston wrote: Sat May 27, 2023 5:09 pm
nisiprius wrote: Fri May 26, 2023 6:39 am As far as I know the Vanguard 500 Index fund was always no-load ...
Just FYI: According to Charles Ellis in his book The Index Fund Revolution, the Vanguard 500 Index fund (originally called the First Index Investment Trust) had a front-end load, which was common for all funds at the time.
John Bogle confirms that to be the case, at least for it's first year, in this writing:
https://www.johncbogle.com/wordpress/wp ... 9-4-11.pdf
The Professor, the Student, and the Index Fund
... His sixth requirement-that it be a no-load fund-had not been met but, he graciously conceded,
"a professor's prayers are rarely answered in full. " As it happened, his final prayer would be answered
only six months later, when in February 1977 the Vanguard funds eliminated all sales charges and made
an unprecedented conversion to a "no-load" distribution system...
Thanks for closing the loop on that point. But Nisiprius also asked a larger question:
Why did loads go away (as they mostly have)? Was Bogle the revolutionary?

A little background:
1. Sales loads were the norm from the 1920s beginning of mutual funds. There were no-load funds even back then, but their proportion of assets under management was miniscule. All the whales were load funds, and the few no-load funds were all minnows.

2. This continued right up to the 1970s: most funds charged a load, and it was mostly substantial: 8% +/-

3. And then things started to change, until by the mid-1980s one could find whales that were no-load—or whales that continued to have a load. Somewhat later there were ETFs, and no ETF ever had or could have a load, as far as I can tell. Loads have become rare today, and those that remain are way smaller than the 8.5% that became traditional by the 1970s.

Why the change? And what was Mr. Bogle’s role?

Vanguard Wellington had a load for the first 18 years of Bogle’s association, with that load going away only in 1977. By that point I think Mr. Bogle had become a causal agent, as part of his larger crusade against costs. But he didn’t light the match.

The best explanation I’ve seen was developed by Joe Nocera: https://www.google.com/books/edition/A_ ... =en&gbpv=0

The first money market fund was launched in 1971; by the end of 1974 there were dozens holding hundreds of millions in assets. In those days bank accounts were regulated in how much they could pay; when interest rates first exploded at the end of the 1960s, millions of ordinary people began to gnash their teeth at the rates they could not get from any bank anywhere.

Money market funds were a market response. It was the easiest sell in the world: “we pay 6.75% on your savings, not 4.25%.” You didn’t need a salesperson to deliver that pitch; a mass media advertisement could do it.

*If your name is not Taylor the 1960s probably predate your investing career—you’ll learn a lot from the Nocera book.

To serve its purpose, a money market fund had to be no-load, as money was expected to move in and out, in and out. Millions of new customers were brought into the mutual fund space through the entry point of money market funds. Which were no-load and could be sold without a salesperson, using just an ad.

These new customers brought that same expectation to other mutual funds. And with a mass customer base, mutual funds now had a distribution channel apart from stockbrokers on whom they had traditionally relied and who were paid the load: the advertisement. In a publication like Money magazine, which started in 1972.

Just as, much later, commissions on stock trades quickly went to zero after the first mover, so also, competition ultimately drove fund loads away. But it took decades. The match was lit in the early 1970s; by the late 1970s Fidelity funds were going no load. But there were plenty of funds that still had a load in 1986, when it became possible to implement a 2-fund index portfolio at Vanguard, at very low cost, with no load.
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by McQ »

JoMoney wrote: Sun May 28, 2023 6:05 pm
McQ wrote: Sun May 28, 2023 5:42 pm...
The thread asks a question: what could the mutual fund investor have got if they had tried to harvest the size effect using the oldest avowedly small cap mutual funds available? ...
FWIW, I haven't seen it mentioned in this thread, but what's regarded as one of the oldest and highest returning mutual funds is the "T Rowe Price Small-Cap Stock Fund" OTCFX , I don't remember if I first read about it from something Mr. Bogle wrote, or from Jeremy Siegel, but it was one of them.
History on it goes back to mid-1956, over the past 67 years it's had something around 12.6% return annualized.
The "survivorship bias" of looking at that fund, without having other small-cap funds over time to compare to is a bit of an issue though.
Also worth pointing out that from 1982 (the first publication on purported Small-cap effect) to present, the funds return are roughly the same (actually a little less) than Vanguard's 500 fund.
I am learning a lot from you, JoMoney, please keep posting.

T. Rowe Price has been no-load for a long time, so that's not an issue here. This particular fund is a puzzle for historians. It was called the TRP OTC fund before 1992. Morningstar indeed shows a chart for the current ticker back to 1956, but here's the head scratcher.

I have Wiesenberger yearbooks for select years back to 1946. The OTC fund is in the 1994 yearbook, but not in the 1990 or any earlier yearbook back to 1956. Either T. Rowe Price bought it, or it was an inhouse fund for decades before TRP made it available to the public (Magellan was that way at Fidelity). Anybody know?

Be that as it may, when I set the Morningstar chart for it to start at December 1981 and end at December 2022, it produces an annualized return of 11.26%, slightly inferior to both the SP 500 fund and the DFA fund, per my OP (11.34%, 11.35%, respectively).

No rescue for the size effect here.
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by JoMoney »

McQ wrote: Sun May 28, 2023 9:48 pm...
Why the change? And what was Mr. Bogle’s role?

Vanguard Wellington had a load for the first 18 years of Bogle’s association, with that load going away only in 1977. By that point I think Mr. Bogle had become a causal agent, as part of his larger crusade against costs. But he didn’t light the match...
Perhaps it was inevitable for sales loads to go away, and Vanguard wasn't first for individual no-load funds, but for a fund company they were ahead of their time blazing a new trail that was less than certain to lead to success
https://johncbogle.com/wordpress/wp-con ... A_2007.pdf
...Our strategy, as I described it in that 1977 speech to NICSA, was to convert our distribution system—overnight and without advance notice—from the commission-based, broker-dealer sold, demand-push system that we had relied on for a full half-century (and that then permeated the industry) to a new no-load, investor-purchased, supply-pull system. When we took this impulsive but monumental step, there was no evidence—none—that it would work. In fact, mutual fund assets had tumbled from $60 billion to $36 billion during the 1972-1974 bear market—yes, you heard those numbers right!—a 40 percent erosion in our asset base, and the industry was in the midst of a wave of net liquidations that would last for 9 of the next 11 years. That was no fun. And, by the way, yes, it could happen again.
A bit of a tangent, but I do remember one of the pitches for funds with loads is that it discouraged active fund traders from coming and going, potentially creating tax issues and additional transaction costs for the fund - and transactions used to be a lot more expensive - at least prior to May 1, 1975 "Wall Street May Day" and the start of discount brokers competing on price...
https://jasonzweig.com/how-may-day-remade-wall-street/
... “One of the great ironies is that the moving force behind May Day was institutional clients who felt they weren’t getting economies of scale,” says trading-cost expert Ananth Madhavan, global head of research for iShares, a division of BlackRock...
... but maybe that also was an impetus for "no load" funds as it was becoming much cheaper for individual investors to buy individual stocks.
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by burritoLover »

Marseille07 wrote: Sun May 28, 2023 10:20 am
burritoLover wrote: Sun May 28, 2023 6:54 am I'm not even sure what you are saying at this point. That risk plays no role in pricing?
I already explained the formula which is "earnings growth + PE change + divs."

Unless you dispute the formula, it is your critical thinking to figure out where risk fits in, if at all.
Before I had a chance to respond, you said something along the lines of risk has little to do with pricing. Regardless, we are a grand canyon away from each other if that's your position.
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by burritoLover »

marcopolo wrote: Sun May 28, 2023 11:14 am
burritoLover wrote: Sun May 28, 2023 7:13 am
marcopolo wrote: Sat May 27, 2023 4:37 pm You are knocking down a strawman.
The whole point is that things are cyclical. It's not that those things are dead now, just like LCG was not dead back when it was underperformed, buy rather that various things lead and lag at different times. No reason to expect one thing to systemically outperform.
BurritoLover wrote: The OP declares that a diversified basket of small caps is not worth investing in. If it isn’t worth investing in, then what else would you call it other than dead? They didn’t say this was just a bad period for small caps and it would improve in the future.
That also seems like a strawman.
I believe what the OP was saying is that there is no benefit to overweighting, or "tilting" to small cap. Just like there is no benefit to doing the same with LCG. The various groups will take turns leading and lagging. So, own a well diversified portfolio, including things that might be declared "dead" at the moment because they are unlikely to stay that way forever.
That's not the impression that I got. They even specifically call out that the post has nothing to do with small-cap value. And they make several mentions that imply that the "size effect" is no longer (i.e. my translation = dead). This isn't a post about the waxing and waning of different sub-asset classes of stocks.
What do you think "size effect" means?
I always thought that meant there was systemic advantage to owning small. That is what the OP is refuting. That does not mean you should not own them. Simply, that you really should not expect outperformance in the long run. Owning them is not dead, getting better returns from over weighting them is dead, or more accurately, was probably never really alive.

If you think "size effect" just means they should be owned, but not over weighted, then we are in agreement. But, that seems contrary to what you are saying in other posts in this thread. You seem to believe that they provide a systemic advantage, that is what the OP says is dead.
The "size effect" refers to the research solidified by Fama and French in their 3-factor model (specifically small-large). The point of the OP - and I'm guessing here because they failed to respond to any of my questions - is that either that size premium has been arbitraged away or is the result of data mining. I'm a little leery when someone tries to claim that an asset class practically as old as the market itself is not worth investing in (my take, that means its "dead"). As far as the 3-factor model, size doesn't look good post-publication - that does not mean there's no risk premium for size at all. And 2 bips an additional expense isn't going to kill anyone on costs in the modern day.
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by burritoLover »

rkhusky wrote: Sun May 28, 2023 6:08 pm
burritoLover wrote: Sun May 28, 2023 9:11 am Not all risk is the same. Some risk is compensated for, other risks are not. You can mitigate the idiosyncratic risk (which you are not compensated for) of an individual stock by adding more stocks to the portfolio. You cannot diversify away systemic risk (that which you are compensated for). For example, you can't diversify in a way that you can have an all-stock portfolio that has stock-like returns with bond-like volatility.
So, is the risk in small caps compensated? For example, can you diversify the idiosyncratic risk of small caps by adding large caps?
That's the crux of the question. Is small cap blend dominated by risk that you are not compensated for (small cap growth "junk" with certain characteristics as has been proposed by factor supporters)? No one knows the answer for sure. I would argue, no, small cap investing is not dead and definitely not convincing from the perspective of comparing a high-fee advisor only fund after the Banz publication to the lowest-fee S&P 500 fund at the time that includes an incredible 10-ish year period where large cap growth absolutely dominated everything.
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by Marseille07 »

burritoLover wrote: Mon May 29, 2023 7:07 am Before I had a chance to respond, you said something along the lines of risk has little to do with pricing. Regardless, we are a grand canyon away from each other if that's your position.
I edited it because you re-asked the same question I had already answered: viewtopic.php?p=7286792#p7286792

I think the problem you have is that you keep talking about expected pricing. I am talking about actual pricing.

As often the case with expected pricing talk, you drink the Kool-aid first, claim XYZ, then other posters point out where XYZ isn't happening, and you're on the back foot and start throwing away inconvenient data by calling something "poison."

In this case your misunderstanding isn't harmful because factors don't matter either way, but it can be.
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by Nowizard »

We have over-weighted a value stock fund for many years, feeling it provides greater diversification. It was our top fund, based on return, last year, right at the bottom of equity funds this year. Over the 15 years or so, it has returned approximately 1% below the Vanguard Total Stock Market annually.

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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by burritoLover »

Marseille07 wrote: Mon May 29, 2023 8:53 am
burritoLover wrote: Mon May 29, 2023 7:07 am Before I had a chance to respond, you said something along the lines of risk has little to do with pricing. Regardless, we are a grand canyon away from each other if that's your position.
I edited it because you re-asked the same question I had already answered: viewtopic.php?p=7286792#p7286792

I think the problem you have is that you keep talking about expected pricing. I am talking about actual pricing.

As often the case with expected pricing talk, you drink the Kool-aid first, claim XYZ, then other posters point out where XYZ isn't happening, and you're on the back foot and start throwing away inconvenient data by calling something "poison."

In this case your misunderstanding isn't harmful because factors don't matter either way, but it can be.
I'm not talking about "expected" pricing whatever that means. If you believe pricing of stocks (in the present tense) has little or nothing to do with risk (your words before your edit), I can't even envision how that would work - investors just ignoring risk entirely in pricing. I guess you'll throw out some more strawmans (lol at your 3rd sentence there) without any real discussion, but maybe I'll be surprised.
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

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McQ wrote: Sun May 28, 2023 9:48 pm
3. And then things started to change, until by the mid-1980s one could find whales that were no-load—or whales that continued to have a load. Somewhat later there were ETFs, and no ETF ever had or could have a load, as far as I can tell. Loads have become rare today, and those that remain are way smaller than the 8.5% that became traditional by the 1970s.
Professor McQ:

To the contrary, after the no-load revolution of the 1980's and 1990's, many formerly no-load mutual fund companies either went to load status themselves or sold themselves to mutual fund companies that went load. This happened in the aftermath of the Tech Crash of 2000 and many former do-it-yourself investors rushed to Advisors. The no-load revolution went into reverse and now I can think of four major fund companies that offer their funds no-load directly to the public: Vanguard, Fidelity, T Rowe Price, and American Century. Dodge & Cox, a boutique value shop, is no load. Can't think of any others off the top of my head. Fortunately, ETFs filled the void left by the implosion of the no-load mutual fund industry.

Are loads rare? I don't know about that. They are alive and well in the Broker-Dealer world and there are still lots of Advisors who sell loaded shares to the public. Ameriprise and Edward Jones still sell load funds to their clients.

Fortunately, there is no reason for an individual investor to pay a load on a mutual fund. No-load funds are available directly through the fund companies mentioned above and certain brokerages give you wide access as well. Investors can skip mutual funds directly and buy the ETFs.
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by Marseille07 »

burritoLover wrote: Mon May 29, 2023 10:13 am I'm not talking about "expected" pricing whatever that means. If you believe pricing of stocks (in the present tense) has little or nothing to do with risk (your words before your edit), I can't even envision how that would work - investors just ignoring risk entirely in pricing. I guess you'll throw out some more strawmans (lol at your 3rd sentence there) without any real discussion, but maybe I'll be surprised.
Why can't you envision how that would work? Do you seriously not understand the formula "earnings growth + PE change + divs"?

This formula is why investors *might* buy equities, not because of volatility.
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by nedsaid »

nisiprius wrote: Sun May 28, 2023 8:05 pm
nedsaid wrote: Sun May 28, 2023 10:34 am
nisiprius wrote: Sat May 27, 2023 1:15 pm
nedsaid wrote: Sat May 27, 2023 11:25 am...The screening for Quality is one reason I am a big fan of the S&P Indexes...
"Screening for quality" doesn't seem to move the needle very much on the actual quality of the portfolio.
How would the S&P 600 Small-Cap Index compare to a CRSP Small-Cap Index? The Morningstar article from a ways back mentioned specifically that a screening for companies that have earnings caused the Small-Cap premium to return with a vengeance. They used the S&P 600 Small-Cap Index as an example of this. Can't remember if they mentioned the Quality factor.
First of all, terrible confession. In the process of moving images around I accidentally compared Vanguard Large-Cap Index with itself. Here's the corrected comparison, and the Vanguard 500 Index Fund does have slightly higher quality:

Image

Second, yes, S&P 600 Small-Cap Index and the Vanguard [CRSP] Small-Cap Index do differ much more in quality.

Image

But the screening for quality did not "cause the Small-Cap premium to return with a vengeance." At least not in real life and not with actual investible funds. we already looked with that upthread. Small-cap Quality underperformed unscreened Small-Cap, and both of them underperformed Large-cap Blend.
I will have to see if I can pull up the Morningstar article, it was probably 3-4 years ago and had a video that went along with it.
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by burritoLover »

Marseille07 wrote: Mon May 29, 2023 10:19 am
burritoLover wrote: Mon May 29, 2023 10:13 am I'm not talking about "expected" pricing whatever that means. If you believe pricing of stocks (in the present tense) has little or nothing to do with risk (your words before your edit), I can't even envision how that would work - investors just ignoring risk entirely in pricing. I guess you'll throw out some more strawmans (lol at your 3rd sentence there) without any real discussion, but maybe I'll be surprised.
Why can't you envision how that would work? Do you seriously not understand the formula "earnings growth + PE change + divs"?

This formula is why investors *might* buy equities, not because of volatility.
Do you understand what PE means? If we have two companies in the same industry, same current earnings, and pay the same dividend, why do you think investors might pay a higher price for $1 of current earnings for one company over the other?
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by Marseille07 »

burritoLover wrote: Mon May 29, 2023 10:33 am Do you understand what PE means? If we have two companies in the same industry, same current earnings, and pay the same dividend, why do you think investors might pay a higher price for $1 of current earnings for one company over the other?
When did I say investors pay a higher price for one of two similar-looking companies? I don't follow your strawman.

A practical answer would be no two companies look so alike as you describe, which nullifies your question altogether.
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by burritoLover »

Marseille07 wrote: Mon May 29, 2023 10:37 am
burritoLover wrote: Mon May 29, 2023 10:33 am Do you understand what PE means? If we have two companies in the same industry, same current earnings, and pay the same dividend, why do you think investors might pay a higher price for $1 of current earnings for one company over the other?
When did I say investors pay a higher price for one of two similar-looking companies? I don't follow your strawman.

A practical answer would be no two companies look so alike as you describe, which nullifies your question altogether.
lol - I gave you a theoretical and you take it as me claiming you said that. Classic.

So, let's say this is true - your answer would be what? They would be priced the same? Or we just going to double down on not directly answering anything?
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by Marseille07 »

burritoLover wrote: Mon May 29, 2023 10:42 am lol - I gave you a theoretical and you take it as me claiming you said that. Classic.

So, let's say this is true - your answer would be what? They would be priced the same? Or we just going to double down on not directly answering anything?
I am not following where you are going with this two companies looking alike example.

But I can still answer it - if there are two identical companies, the investors can value each of them however they want. Is it rational to value them differently, probably not. But there is a famous quote which says “markets can remain irrational longer than you can remain solvent."
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by burritoLover »

Marseille07 wrote: Mon May 29, 2023 10:50 am
burritoLover wrote: Mon May 29, 2023 10:42 am lol - I gave you a theoretical and you take it as me claiming you said that. Classic.

So, let's say this is true - your answer would be what? They would be priced the same? Or we just going to double down on not directly answering anything?
I am not following where you are going with this two companies looking alike example.

But I can still answer it - if there are two identical companies, the investors can value each of them however they want. Is it rational to value them differently, probably not. But there is a famous quote which says “markets can remain irrational longer than you can remain solvent."
Ok, let's get more specific. We have two pharmaceutical companies, company A and company B. Both are fairly similar as far as earnings, price-to-earnings and dividend yield and they both sell similar products (note, I did not say identical). This is not out of the realm of possibility. Company A just announced that they have a promising new drug that cures male pattern baldness. Company B doesn't have really anything promising at the moment. Now, Bob Jones of Kansas might wonder why anyone should care about curing male pattern baldness but let's consider the aggregate of all investors who believe this has a high probability of being approved by the FDA and think that this has the potential of generating larger cash flows in the future for company A than the current price would reflect. Therefore, the aggregate of investors (again not every investor) would be willing to pay a higher price for company A than company B, even though current earnings have not changed. Why? Because those future cash flows for company A have now become less risky than company B. Now, not every investor has the same conviction about this - but there's an equilibrium that is reached in pricing from the aggregate of all buyers and sellers.

In a parallel universe, where investors don't consider risk, then the price of company A and B would remain the same - because, risk has little to do with pricing. Instead, the market would wait until the drug gets FDA approval, is on the market, and company A's earnings actually go up before the price changes.
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by marcopolo »

burritoLover wrote: Mon May 29, 2023 7:13 am
marcopolo wrote: Sun May 28, 2023 11:14 am
burritoLover wrote: Sun May 28, 2023 7:13 am
marcopolo wrote: Sat May 27, 2023 4:37 pm You are knocking down a strawman.
The whole point is that things are cyclical. It's not that those things are dead now, just like LCG was not dead back when it was underperformed, buy rather that various things lead and lag at different times. No reason to expect one thing to systemically outperform.
BurritoLover wrote: The OP declares that a diversified basket of small caps is not worth investing in. If it isn’t worth investing in, then what else would you call it other than dead? They didn’t say this was just a bad period for small caps and it would improve in the future.
That also seems like a strawman.
I believe what the OP was saying is that there is no benefit to overweighting, or "tilting" to small cap. Just like there is no benefit to doing the same with LCG. The various groups will take turns leading and lagging. So, own a well diversified portfolio, including things that might be declared "dead" at the moment because they are unlikely to stay that way forever.
That's not the impression that I got. They even specifically call out that the post has nothing to do with small-cap value. And they make several mentions that imply that the "size effect" is no longer (i.e. my translation = dead). This isn't a post about the waxing and waning of different sub-asset classes of stocks.
What do you think "size effect" means?
I always thought that meant there was systemic advantage to owning small. That is what the OP is refuting. That does not mean you should not own them. Simply, that you really should not expect outperformance in the long run. Owning them is not dead, getting better returns from over weighting them is dead, or more accurately, was probably never really alive.

If you think "size effect" just means they should be owned, but not over weighted, then we are in agreement. But, that seems contrary to what you are saying in other posts in this thread. You seem to believe that they provide a systemic advantage, that is what the OP says is dead.
The "size effect" refers to the research solidified by Fama and French in their 3-factor model (specifically small-large). The point of the OP - and I'm guessing here because they failed to respond to any of my questions - is that either that size premium has been arbitraged away or is the result of data mining. I'm a little leery when someone tries to claim that an asset class practically as old as the market itself is not worth investing in (my take, that means its "dead"). As far as the 3-factor model, size doesn't look good post-publication - that does not mean there's no risk premium for size at all. And 2 bips an additional expense isn't going to kill anyone on costs in the modern day.
OK, I am with you on the definition.

I don't get how you are making the leap from the first highlighted statement to the second.

You do realize that it is possible to invest in something with out over weighting it in your portfolio, right?

If you think it will provide a premium, the suggestion might be to over weight it in hopes of capturing the premium.

If you think it will wax and wane, but not provide any premium in the long term, the suggestion might be to own it at Market weight to capture the periods where it does do better than your other assets.

I read the OP as suggesting the latter. The premium might be dead, but that does not mean you don't invest in it at all. Just that there might not be any advantage to over weighting it.
Once in a while you get shown the light, in the strangest of places if you look at it right.
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by Marseille07 »

burritoLover wrote: Mon May 29, 2023 11:11 am Ok, let's get more specific. We have two pharmaceutical companies, company A and company B. Both are fairly similar as far as earnings, price-to-earnings and dividend yield and they both sell similar products (note, I did not say identical). This is not out of the realm of possibility. Company A just announced that they have a promising new drug that cures male pattern baldness. Company B doesn't have really anything promising at the moment. Now, Bob Jones of Kansas might wonder why anyone should care about curing male pattern baldness but let's consider the aggregate of all investors who believe this has a high probability of being approved by the FDA and think that this has the potential of generating larger cash flows in the future for company A than the current price would reflect. Therefore, the aggregate of investors (again not every investor) would be willing to pay a higher price for company A than company B, even though current earnings have not changed. Why? Because those future cash flows for company A have now become less risky than company B. Now, not every investor has the same conviction about this - but there's an equilibrium that is reached in pricing from the aggregate of all buyers and sellers.

In a parallel universe, where investors don't consider risk, then the price of company A and B would remain the same - because, risk has little to do with pricing. Instead, the market would wait until the drug gets FDA approval, is on the market, and company A's earnings actually go up before the price changes.
In this scenario, investors might pay more for Company A because of a drug pending FDA approval.

Now, obviously the FDA approval isn't guaranteed and there is risk; but it doesn't mean the risk is driving home the return. The actual driver of Company A in this scenario is a better future outlook of Company A in terms of their earnings once the drug hits the market.
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by burritoLover »

Marseille07 wrote: Mon May 29, 2023 11:27 am
burritoLover wrote: Mon May 29, 2023 11:11 am Ok, let's get more specific. We have two pharmaceutical companies, company A and company B. Both are fairly similar as far as earnings, price-to-earnings and dividend yield and they both sell similar products (note, I did not say identical). This is not out of the realm of possibility. Company A just announced that they have a promising new drug that cures male pattern baldness. Company B doesn't have really anything promising at the moment. Now, Bob Jones of Kansas might wonder why anyone should care about curing male pattern baldness but let's consider the aggregate of all investors who believe this has a high probability of being approved by the FDA and think that this has the potential of generating larger cash flows in the future for company A than the current price would reflect. Therefore, the aggregate of investors (again not every investor) would be willing to pay a higher price for company A than company B, even though current earnings have not changed. Why? Because those future cash flows for company A have now become less risky than company B. Now, not every investor has the same conviction about this - but there's an equilibrium that is reached in pricing from the aggregate of all buyers and sellers.

In a parallel universe, where investors don't consider risk, then the price of company A and B would remain the same - because, risk has little to do with pricing. Instead, the market would wait until the drug gets FDA approval, is on the market, and company A's earnings actually go up before the price changes.
In this scenario, investors might pay more for Company A because of a drug pending FDA approval.

Now, obviously the FDA approval isn't guaranteed and there is risk; but it doesn't mean the risk is driving home the return. The actual driver of Company A in this scenario is a better future outlook of Company A in terms of their earnings once the drug hits the market.
Is a better future outlook less risky to future returns?
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by burritoLover »

marcopolo wrote: Mon May 29, 2023 11:26 am
burritoLover wrote: Mon May 29, 2023 7:13 am
marcopolo wrote: Sun May 28, 2023 11:14 am
burritoLover wrote: Sun May 28, 2023 7:13 am
marcopolo wrote: Sat May 27, 2023 4:37 pm You are knocking down a strawman.
The whole point is that things are cyclical. It's not that those things are dead now, just like LCG was not dead back when it was underperformed, buy rather that various things lead and lag at different times. No reason to expect one thing to systemically outperform.


That also seems like a strawman.
I believe what the OP was saying is that there is no benefit to overweighting, or "tilting" to small cap. Just like there is no benefit to doing the same with LCG. The various groups will take turns leading and lagging. So, own a well diversified portfolio, including things that might be declared "dead" at the moment because they are unlikely to stay that way forever.
That's not the impression that I got. They even specifically call out that the post has nothing to do with small-cap value. And they make several mentions that imply that the "size effect" is no longer (i.e. my translation = dead). This isn't a post about the waxing and waning of different sub-asset classes of stocks.
What do you think "size effect" means?
I always thought that meant there was systemic advantage to owning small. That is what the OP is refuting. That does not mean you should not own them. Simply, that you really should not expect outperformance in the long run. Owning them is not dead, getting better returns from over weighting them is dead, or more accurately, was probably never really alive.

If you think "size effect" just means they should be owned, but not over weighted, then we are in agreement. But, that seems contrary to what you are saying in other posts in this thread. You seem to believe that they provide a systemic advantage, that is what the OP says is dead.
The "size effect" refers to the research solidified by Fama and French in their 3-factor model (specifically small-large). The point of the OP - and I'm guessing here because they failed to respond to any of my questions - is that either that size premium has been arbitraged away or is the result of data mining. I'm a little leery when someone tries to claim that an asset class practically as old as the market itself is not worth investing in (my take, that means its "dead"). As far as the 3-factor model, size doesn't look good post-publication - that does not mean there's no risk premium for size at all. And 2 bips an additional expense isn't going to kill anyone on costs in the modern day.
OK, I am with you on the definition.

I don't get how you are making the leap from the first highlighted statement to the second.

You do realize that it is possible to invest in something with out over weighting it in your portfolio, right?

If you think it will provide a premium, the suggestion might be to over weight it in hopes of capturing the premium.

If you think it will wax and wane, but not provide any premium in the long term, the suggestion might be to own it at Market weight to capture the periods where it does do better than your other assets.

I read the OP as suggesting the latter. The premium might be dead, but that does not mean you don't invest in it at all. Just that there might not be any advantage to over weighting it.
I agree with that - I'm not saying the OP is claiming to exclude small caps from a portfolio entirely. I'm saying that their conclusion that tilting to small caps is entirely irrelevant (with the expectation of practically little return) is flawed based on what they presented. When we talk about an asset class being "dead" - such as was the case with value from some in the financial media in recent years, they aren't saying you should invest in only growth stocks if you are a MCW investor. They're saying that the factor premium is dead in this case and that there's no logical reason to tilt towards that factor net of costs.
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by Marseille07 »

burritoLover wrote: Mon May 29, 2023 11:32 am Is a better future outlook less risky to future returns?
That's too vague of a question. How much is better and how much is risky? What is the likelihood of an FDA approval? How much did Company A's stock go up by vs Company B? We need to consider all these questions, and there's probably no black & white answer even then.
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by burritoLover »

Marseille07 wrote: Mon May 29, 2023 11:47 am
burritoLover wrote: Mon May 29, 2023 11:32 am Is a better future outlook less risky to future returns?
That's too vague of a question. How much is better and how much is risky? What is the likelihood of an FDA approval? How much did Company A's stock go up by vs Company B? We need to consider all these questions, and there's probably no black & white answer even then.
The likelihood of FDA approval is a near-certainty. This announcement is huge - the aggregate of investors think it has the potential impact earnings by 10x. The price has not gone up yet - we are looking at the moment of the announcement. Remember, company A and B have a similar PE at this point. That pricing is based on what is known before the announcement (i.e. no baldness drug for company A). So, again, is a better future outlook for earnings in this case, less risky to future returns? I'm done if you are just going to double-down on your "unknowable" answer.
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by Marseille07 »

burritoLover wrote: Mon May 29, 2023 11:59 am The likelihood of FDA approval is a near-certainty. This announcement is huge - the aggregate of investors think it has the potential impact earnings by 10x. The price has not gone up yet - we are looking at the moment of the announcement. Remember, company A and B have a similar PE at this point. That pricing is based on what is known before the announcement (i.e. no baldness drug for company A). So, again, is a better future outlook for earnings in this case, less risky to future returns? I'm done if you are just going to double-down on your "unknowable" answer.
If the FDA approval & subsequent business prospects are near-certain to unfold as Company A projects, it's less risky. But I still don't see what risk has anything to do with this. Company A's stock could go up because "it has the potential impact earnings by 10x," not because it is more volatile on the pending FDA approval.
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by burritoLover »

Marseille07 wrote: Mon May 29, 2023 12:06 pm
burritoLover wrote: Mon May 29, 2023 11:59 am The likelihood of FDA approval is a near-certainty. This announcement is huge - the aggregate of investors think it has the potential impact earnings by 10x. The price has not gone up yet - we are looking at the moment of the announcement. Remember, company A and B have a similar PE at this point. That pricing is based on what is known before the announcement (i.e. no baldness drug for company A). So, again, is a better future outlook for earnings in this case, less risky to future returns? I'm done if you are just going to double-down on your "unknowable" answer.
If the FDA approval & subsequent business prospects are near-certain to unfold as Company A projects, it's less risky. But I still don't see what risk has anything to do with this. Company A's stock could go up because "it has the potential impact earnings by 10x," not because it is more volatile on the pending FDA approval.
Prior to the announcement, both of these companies are priced for similar future cashflows. With the announcement, but an an instant before any price change occurs, achieving the expected future cashflows on company A at the current price just became a lot less risky. Therefore, the price goes up, due to the investor's evaluation of risk (and higher expected future cashflows). Eureka - investors consider risk when they price securities.

We could do an opposite example where the new news is company B's profitable drug has to be pulled off the market due to side effects. Company B future cashflows are now more risky and hence, the price will drop.
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by Marseille07 »

burritoLover wrote: Mon May 29, 2023 12:25 pm Prior to the announcement, both of these companies are priced for similar future cashflows. With the announcement, but an an instant before any price change occurs, achieving the expected future cashflows on company A at the current price just became a lot less risky. Therefore, the price goes up, due to the investor's evaluation of risk (and higher expected future cashflows). Eureka - investors consider risk when they price securities.

We could do an opposite example where the new news is company B's profitable drug has to be pulled off the market due to side effects. Company B future cashflows are now more risky and hence, the price will drop.
I just explained to you that Company A's stock price might go up due to future earnings growth, not risk of cashflows.

It's no different than companies reporting earnings and the CFO mentioning a better future outlook during the earnings call.
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by burritoLover »

Marseille07 wrote: Mon May 29, 2023 12:51 pm
burritoLover wrote: Mon May 29, 2023 12:25 pm Prior to the announcement, both of these companies are priced for similar future cashflows. With the announcement, but an an instant before any price change occurs, achieving the expected future cashflows on company A at the current price just became a lot less risky. Therefore, the price goes up, due to the investor's evaluation of risk (and higher expected future cashflows). Eureka - investors consider risk when they price securities.

We could do an opposite example where the new news is company B's profitable drug has to be pulled off the market due to side effects. Company B future cashflows are now more risky and hence, the price will drop.
I just explained to you that Company A's stock price might go up due to future earnings growth, not risk of cashflows.

It's no different than companies reporting earnings and the CFO mentioning a better future outlook during the earnings call.
Do you expect a higher total return for stocks over bonds in the long-run? If so, why? What about long bonds over short bonds?
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by Marseille07 »

burritoLover wrote: Mon May 29, 2023 12:58 pm Do you expect a higher total return for stocks over bonds in the long-run? If so, why? What about long bonds over short bonds?
1) Yes, because "earnings growth + change in PE + divs" is likely higher than the bond yield.
2) That entirely depends on the yield when you buy the instruments. For example, long bonds might earn less during an inverted yield curve.
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by secondopinion »

burritoLover wrote: Mon May 29, 2023 12:25 pm
Marseille07 wrote: Mon May 29, 2023 12:06 pm
burritoLover wrote: Mon May 29, 2023 11:59 am The likelihood of FDA approval is a near-certainty. This announcement is huge - the aggregate of investors think it has the potential impact earnings by 10x. The price has not gone up yet - we are looking at the moment of the announcement. Remember, company A and B have a similar PE at this point. That pricing is based on what is known before the announcement (i.e. no baldness drug for company A). So, again, is a better future outlook for earnings in this case, less risky to future returns? I'm done if you are just going to double-down on your "unknowable" answer.
If the FDA approval & subsequent business prospects are near-certain to unfold as Company A projects, it's less risky. But I still don't see what risk has anything to do with this. Company A's stock could go up because "it has the potential impact earnings by 10x," not because it is more volatile on the pending FDA approval.
Prior to the announcement, both of these companies are priced for similar future cashflows. With the announcement, but an an instant before any price change occurs, achieving the expected future cashflows on company A at the current price just became a lot less risky. Therefore, the price goes up, due to the investor's evaluation of risk (and higher expected future cashflows). Eureka - investors consider risk when they price securities.

We could do an opposite example where the new news is company B's profitable drug has to be pulled off the market due to side effects. Company B future cashflows are now more risky and hence, the price will drop.
The prices go up because the expected future earnings have increased. However, stock A has actually increased in volatility as well because the priced in increase of expected future earnings is not certain. Once the approval is granted and the drug has been out for a while, then the volatility will settle as the actual earnings are more reliable.

Stock B has a reduction of expected future earnings; therefore, the price drops. However, there is an increase of volatility because that loss is not certain (maybe Company B can resolve the side effect by a slight reformulation). Once it is clear nothing will change, then the volatility will settle.

Company A is not safer than Company B given one drug is not a big deal either way; volatility will increase for both of them. As one approaches the limit of operating on “going concern”, then will Company A be seen as safer than Company B (the probability distribution of potential earnings start to be skewed very positively rather than symmetrically).

But remember, companies with high PE and good growth potential (meaning high expected future earnings) can be very volatile anyway because they are risky. I still do not believe that growth is safer than value (which this side-discussion suggests) because I have observed enough stocks to conclude otherwise (it can be risky either way).
Last edited by secondopinion on Mon May 29, 2023 1:24 pm, edited 1 time in total.
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by secondopinion »

burritoLover wrote: Mon May 29, 2023 12:58 pm
Marseille07 wrote: Mon May 29, 2023 12:51 pm
burritoLover wrote: Mon May 29, 2023 12:25 pm Prior to the announcement, both of these companies are priced for similar future cashflows. With the announcement, but an an instant before any price change occurs, achieving the expected future cashflows on company A at the current price just became a lot less risky. Therefore, the price goes up, due to the investor's evaluation of risk (and higher expected future cashflows). Eureka - investors consider risk when they price securities.

We could do an opposite example where the new news is company B's profitable drug has to be pulled off the market due to side effects. Company B future cashflows are now more risky and hence, the price will drop.
I just explained to you that Company A's stock price might go up due to future earnings growth, not risk of cashflows.

It's no different than companies reporting earnings and the CFO mentioning a better future outlook during the earnings call.
Do you expect a higher total return for stocks over bonds in the long-run? If so, why? What about long bonds over short bonds?
The skew of market returns is more negatively skewed; therefore, it is more likely to outperform long-term bonds regardless if a premium exists. It can do so by solely odds.

I would have to look at the skew, but the kurtosis of shorter-term bonds could allow for more intense tail cases if leveraged to equal volatility of long-term bonds. It is kind of unclear in my opinion as to which one will be more profitable; especially if leverage is disallowed.
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by burritoLover »

secondopinion wrote: Mon May 29, 2023 1:06 pm
burritoLover wrote: Mon May 29, 2023 12:25 pm
Marseille07 wrote: Mon May 29, 2023 12:06 pm
burritoLover wrote: Mon May 29, 2023 11:59 am The likelihood of FDA approval is a near-certainty. This announcement is huge - the aggregate of investors think it has the potential impact earnings by 10x. The price has not gone up yet - we are looking at the moment of the announcement. Remember, company A and B have a similar PE at this point. That pricing is based on what is known before the announcement (i.e. no baldness drug for company A). So, again, is a better future outlook for earnings in this case, less risky to future returns? I'm done if you are just going to double-down on your "unknowable" answer.
If the FDA approval & subsequent business prospects are near-certain to unfold as Company A projects, it's less risky. But I still don't see what risk has anything to do with this. Company A's stock could go up because "it has the potential impact earnings by 10x," not because it is more volatile on the pending FDA approval.
Prior to the announcement, both of these companies are priced for similar future cashflows. With the announcement, but an an instant before any price change occurs, achieving the expected future cashflows on company A at the current price just became a lot less risky. Therefore, the price goes up, due to the investor's evaluation of risk (and higher expected future cashflows). Eureka - investors consider risk when they price securities.

We could do an opposite example where the new news is company B's profitable drug has to be pulled off the market due to side effects. Company B future cashflows are now more risky and hence, the price will drop.
The prices go up because the expected future earnings have increased. However, stock A has actually increased in volatility as well because the priced in increase of expected future earnings is not certain. Once the approval is granted and the drug has been out for a while, then the volatility will settle as the actual earnings are more reliable.

Stock B has a reduction of expected future earnings; therefore, the price drops. However, there is an increase of volatility because that loss is not certain (maybe Company B can resolve the side effect by a slight reformulation). Once it is clear nothing will change, then the volatility will settle.

Company A is not safer than Company B given one drug is not a big deal either way; volatility will increase for both of them. As one approaches the limit of operating on “going concern”, then will Company A be seen as safer than Company B (the distribution of potential earnings start to be skewed very positively rather than symmetrically).

But remember, companies with high PE and good growth potential (meaning high expected future earnings) can be very volatile anyway because they are risky. I still do not believe that growth is safer than value (which this side-discussion suggests) because I have observed enough stocks to conclude otherwise (it can be risky either way).
If you want to frame it another way that is easier to visualize - let's say both company A and B both announce new but different drugs at the same time, the market believes each will have the same effect on earnings for both companies and have an equal chance of getting FDA approval. As it turns out, Company A happens to get FDA approval first. Company A's price will go up based on the fact that its future earnings are less risky than before.

It seems both you and Marsailles think that the only risk that exists in market pricing is the risk of volatility.
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by burritoLover »

secondopinion wrote: Mon May 29, 2023 1:20 pm
burritoLover wrote: Mon May 29, 2023 12:58 pm
Marseille07 wrote: Mon May 29, 2023 12:51 pm
burritoLover wrote: Mon May 29, 2023 12:25 pm Prior to the announcement, both of these companies are priced for similar future cashflows. With the announcement, but an an instant before any price change occurs, achieving the expected future cashflows on company A at the current price just became a lot less risky. Therefore, the price goes up, due to the investor's evaluation of risk (and higher expected future cashflows). Eureka - investors consider risk when they price securities.

We could do an opposite example where the new news is company B's profitable drug has to be pulled off the market due to side effects. Company B future cashflows are now more risky and hence, the price will drop.
I just explained to you that Company A's stock price might go up due to future earnings growth, not risk of cashflows.

It's no different than companies reporting earnings and the CFO mentioning a better future outlook during the earnings call.
Do you expect a higher total return for stocks over bonds in the long-run? If so, why? What about long bonds over short bonds?
The skew of market returns is more negatively skewed; therefore, it is more likely to outperform long-term bonds regardless if a premium exists. It can do so by solely odds.

I would have to look at the skew, but the kurtosis of shorter-term bonds could allow for more intense tail cases if leveraged to equal volatility of long-term bonds. It is kind of unclear in my opinion as to which one will be more profitable; especially if leverage is disallowed.
So how should a 10-year treasury bond be priced compared to a 10-year corporate bond? I guess that has nothing to do with risk lol.
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by secondopinion »

burritoLover wrote: Mon May 29, 2023 1:39 pm
secondopinion wrote: Mon May 29, 2023 1:06 pm
burritoLover wrote: Mon May 29, 2023 12:25 pm
Marseille07 wrote: Mon May 29, 2023 12:06 pm
burritoLover wrote: Mon May 29, 2023 11:59 am The likelihood of FDA approval is a near-certainty. This announcement is huge - the aggregate of investors think it has the potential impact earnings by 10x. The price has not gone up yet - we are looking at the moment of the announcement. Remember, company A and B have a similar PE at this point. That pricing is based on what is known before the announcement (i.e. no baldness drug for company A). So, again, is a better future outlook for earnings in this case, less risky to future returns? I'm done if you are just going to double-down on your "unknowable" answer.
If the FDA approval & subsequent business prospects are near-certain to unfold as Company A projects, it's less risky. But I still don't see what risk has anything to do with this. Company A's stock could go up because "it has the potential impact earnings by 10x," not because it is more volatile on the pending FDA approval.
Prior to the announcement, both of these companies are priced for similar future cashflows. With the announcement, but an an instant before any price change occurs, achieving the expected future cashflows on company A at the current price just became a lot less risky. Therefore, the price goes up, due to the investor's evaluation of risk (and higher expected future cashflows). Eureka - investors consider risk when they price securities.

We could do an opposite example where the new news is company B's profitable drug has to be pulled off the market due to side effects. Company B future cashflows are now more risky and hence, the price will drop.
The prices go up because the expected future earnings have increased. However, stock A has actually increased in volatility as well because the priced in increase of expected future earnings is not certain. Once the approval is granted and the drug has been out for a while, then the volatility will settle as the actual earnings are more reliable.

Stock B has a reduction of expected future earnings; therefore, the price drops. However, there is an increase of volatility because that loss is not certain (maybe Company B can resolve the side effect by a slight reformulation). Once it is clear nothing will change, then the volatility will settle.

Company A is not safer than Company B given one drug is not a big deal either way; volatility will increase for both of them. As one approaches the limit of operating on “going concern”, then will Company A be seen as safer than Company B (the distribution of potential earnings start to be skewed very positively rather than symmetrically).

But remember, companies with high PE and good growth potential (meaning high expected future earnings) can be very volatile anyway because they are risky. I still do not believe that growth is safer than value (which this side-discussion suggests) because I have observed enough stocks to conclude otherwise (it can be risky either way).
If you want to frame it another way that is easier to visualize - let's say both company A and B both announce new but different drugs at the same time, the market believes each will have the same effect on earnings for both companies and have an equal chance of getting FDA approval. As it turns out, Company A happens to get FDA approval first. Company A's price will go up based on the fact that its future earnings are less risky than before.

It seems both you and Marsailles think that the only risk that exists in market pricing is the risk of volatility.
Actually, I did make a comment about positive skew on companies operating poorly. The risk may or may not symmetric depending on how critical of an event it is. Volatility is only symmetrical by itself. It is a risk that volatility can change.
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by burritoLover »

secondopinion wrote: Mon May 29, 2023 2:03 pm
burritoLover wrote: Mon May 29, 2023 1:39 pm
secondopinion wrote: Mon May 29, 2023 1:06 pm
burritoLover wrote: Mon May 29, 2023 12:25 pm
Marseille07 wrote: Mon May 29, 2023 12:06 pm

If the FDA approval & subsequent business prospects are near-certain to unfold as Company A projects, it's less risky. But I still don't see what risk has anything to do with this. Company A's stock could go up because "it has the potential impact earnings by 10x," not because it is more volatile on the pending FDA approval.
Prior to the announcement, both of these companies are priced for similar future cashflows. With the announcement, but an an instant before any price change occurs, achieving the expected future cashflows on company A at the current price just became a lot less risky. Therefore, the price goes up, due to the investor's evaluation of risk (and higher expected future cashflows). Eureka - investors consider risk when they price securities.

We could do an opposite example where the new news is company B's profitable drug has to be pulled off the market due to side effects. Company B future cashflows are now more risky and hence, the price will drop.
The prices go up because the expected future earnings have increased. However, stock A has actually increased in volatility as well because the priced in increase of expected future earnings is not certain. Once the approval is granted and the drug has been out for a while, then the volatility will settle as the actual earnings are more reliable.

Stock B has a reduction of expected future earnings; therefore, the price drops. However, there is an increase of volatility because that loss is not certain (maybe Company B can resolve the side effect by a slight reformulation). Once it is clear nothing will change, then the volatility will settle.

Company A is not safer than Company B given one drug is not a big deal either way; volatility will increase for both of them. As one approaches the limit of operating on “going concern”, then will Company A be seen as safer than Company B (the distribution of potential earnings start to be skewed very positively rather than symmetrically).

But remember, companies with high PE and good growth potential (meaning high expected future earnings) can be very volatile anyway because they are risky. I still do not believe that growth is safer than value (which this side-discussion suggests) because I have observed enough stocks to conclude otherwise (it can be risky either way).
If you want to frame it another way that is easier to visualize - let's say both company A and B both announce new but different drugs at the same time, the market believes each will have the same effect on earnings for both companies and have an equal chance of getting FDA approval. As it turns out, Company A happens to get FDA approval first. Company A's price will go up based on the fact that its future earnings are less risky than before.

It seems both you and Marsailles think that the only risk that exists in market pricing is the risk of volatility.
Actually, I did make a comment about positive skew on companies operating poorly. The risk may or may not symmetric depending on how critical of an event it is. Volatility is only symmetrical by itself. It is a risk that volatility can change.
Ok, so Marsailles believes that risk has little to nothing to do with pricing of stocks. Is that your position as well?
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by secondopinion »

burritoLover wrote: Mon May 29, 2023 1:43 pm
secondopinion wrote: Mon May 29, 2023 1:20 pm
burritoLover wrote: Mon May 29, 2023 12:58 pm
Marseille07 wrote: Mon May 29, 2023 12:51 pm
burritoLover wrote: Mon May 29, 2023 12:25 pm Prior to the announcement, both of these companies are priced for similar future cashflows. With the announcement, but an an instant before any price change occurs, achieving the expected future cashflows on company A at the current price just became a lot less risky. Therefore, the price goes up, due to the investor's evaluation of risk (and higher expected future cashflows). Eureka - investors consider risk when they price securities.

We could do an opposite example where the new news is company B's profitable drug has to be pulled off the market due to side effects. Company B future cashflows are now more risky and hence, the price will drop.
I just explained to you that Company A's stock price might go up due to future earnings growth, not risk of cashflows.

It's no different than companies reporting earnings and the CFO mentioning a better future outlook during the earnings call.
Do you expect a higher total return for stocks over bonds in the long-run? If so, why? What about long bonds over short bonds?
The skew of market returns is more negatively skewed; therefore, it is more likely to outperform long-term bonds regardless if a premium exists. It can do so by solely odds.

I would have to look at the skew, but the kurtosis of shorter-term bonds could allow for more intense tail cases if leveraged to equal volatility of long-term bonds. It is kind of unclear in my opinion as to which one will be more profitable; especially if leverage is disallowed.
So how should a 10-year treasury bond be priced compared to a 10-year corporate bond? I guess that has nothing to do with risk lol.
Corporate bonds must compensate for a minimum of the expected loss from default. Furthermore, corporate bonds are usually negatively skewed with their risk; therefore, they are usually profitable over treasury bonds.

If one realizes that risk is not symmetrical and can have kurtosis, a lot can be said that is odds driven.
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by burritoLover »

secondopinion wrote: Mon May 29, 2023 2:09 pm
burritoLover wrote: Mon May 29, 2023 1:43 pm
secondopinion wrote: Mon May 29, 2023 1:20 pm
burritoLover wrote: Mon May 29, 2023 12:58 pm
Marseille07 wrote: Mon May 29, 2023 12:51 pm

I just explained to you that Company A's stock price might go up due to future earnings growth, not risk of cashflows.

It's no different than companies reporting earnings and the CFO mentioning a better future outlook during the earnings call.
Do you expect a higher total return for stocks over bonds in the long-run? If so, why? What about long bonds over short bonds?
The skew of market returns is more negatively skewed; therefore, it is more likely to outperform long-term bonds regardless if a premium exists. It can do so by solely odds.

I would have to look at the skew, but the kurtosis of shorter-term bonds could allow for more intense tail cases if leveraged to equal volatility of long-term bonds. It is kind of unclear in my opinion as to which one will be more profitable; especially if leverage is disallowed.
So how should a 10-year treasury bond be priced compared to a 10-year corporate bond? I guess that has nothing to do with risk lol.
Corporate bonds must compensate for a minimum of the expected loss from default. Furthermore, corporate bonds are usually negatively skewed with their risk; therefore, they are usually profitable over treasury bonds.

If one realizes that risk is not symmetrical and can have kurtosis, a lot can be said that is odds driven.
lol - so corporate bonds must compensate for the expected loss of default - which is what? What's the word I'm searching for? Oh yeah, a risk, which means corporate bonds are priced relative to treasuries based on their risk of default. Apparently you think the market cannot price risk unless it follows a normal distribution is your other point?

I think I'm just getting trolled at this point.
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by secondopinion »

burritoLover wrote: Mon May 29, 2023 2:08 pm
secondopinion wrote: Mon May 29, 2023 2:03 pm
burritoLover wrote: Mon May 29, 2023 1:39 pm
secondopinion wrote: Mon May 29, 2023 1:06 pm
burritoLover wrote: Mon May 29, 2023 12:25 pm
Prior to the announcement, both of these companies are priced for similar future cashflows. With the announcement, but an an instant before any price change occurs, achieving the expected future cashflows on company A at the current price just became a lot less risky. Therefore, the price goes up, due to the investor's evaluation of risk (and higher expected future cashflows). Eureka - investors consider risk when they price securities.

We could do an opposite example where the new news is company B's profitable drug has to be pulled off the market due to side effects. Company B future cashflows are now more risky and hence, the price will drop.
The prices go up because the expected future earnings have increased. However, stock A has actually increased in volatility as well because the priced in increase of expected future earnings is not certain. Once the approval is granted and the drug has been out for a while, then the volatility will settle as the actual earnings are more reliable.

Stock B has a reduction of expected future earnings; therefore, the price drops. However, there is an increase of volatility because that loss is not certain (maybe Company B can resolve the side effect by a slight reformulation). Once it is clear nothing will change, then the volatility will settle.

Company A is not safer than Company B given one drug is not a big deal either way; volatility will increase for both of them. As one approaches the limit of operating on “going concern”, then will Company A be seen as safer than Company B (the distribution of potential earnings start to be skewed very positively rather than symmetrically).

But remember, companies with high PE and good growth potential (meaning high expected future earnings) can be very volatile anyway because they are risky. I still do not believe that growth is safer than value (which this side-discussion suggests) because I have observed enough stocks to conclude otherwise (it can be risky either way).
If you want to frame it another way that is easier to visualize - let's say both company A and B both announce new but different drugs at the same time, the market believes each will have the same effect on earnings for both companies and have an equal chance of getting FDA approval. As it turns out, Company A happens to get FDA approval first. Company A's price will go up based on the fact that its future earnings are less risky than before.

It seems both you and Marsailles think that the only risk that exists in market pricing is the risk of volatility.
Actually, I did make a comment about positive skew on companies operating poorly. The risk may or may not symmetric depending on how critical of an event it is. Volatility is only symmetrical by itself. It is a risk that volatility can change.
Ok, so Marsailles believes that risk has little to nothing to do with pricing of stocks. Is that your position as well?
Risk is not absolutely measured because every person differs as to their assessment. In general, it has to be priced according to expected future earnings. What the probability distribution of potential future earnings is always the question (high PE does not exactly mean high expected future earnings as the likely outcome). One has to define if their risk measure is long-term or short-term volatility, whether skew or kurtosis slants are “risky”, and so on. And then determine what reward they expect, which the market might not agree with their assessment.
Last edited by secondopinion on Mon May 29, 2023 2:39 pm, edited 2 times in total.
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by secondopinion »

burritoLover wrote: Mon May 29, 2023 2:21 pm
secondopinion wrote: Mon May 29, 2023 2:09 pm
burritoLover wrote: Mon May 29, 2023 1:43 pm
secondopinion wrote: Mon May 29, 2023 1:20 pm
burritoLover wrote: Mon May 29, 2023 12:58 pm
Do you expect a higher total return for stocks over bonds in the long-run? If so, why? What about long bonds over short bonds?
The skew of market returns is more negatively skewed; therefore, it is more likely to outperform long-term bonds regardless if a premium exists. It can do so by solely odds.

I would have to look at the skew, but the kurtosis of shorter-term bonds could allow for more intense tail cases if leveraged to equal volatility of long-term bonds. It is kind of unclear in my opinion as to which one will be more profitable; especially if leverage is disallowed.
So how should a 10-year treasury bond be priced compared to a 10-year corporate bond? I guess that has nothing to do with risk lol.
Corporate bonds must compensate for a minimum of the expected loss from default. Furthermore, corporate bonds are usually negatively skewed with their risk; therefore, they are usually profitable over treasury bonds.

If one realizes that risk is not symmetrical and can have kurtosis, a lot can be said that is odds driven.
lol - so corporate bonds must compensate for the expected loss of default - which is what? What's the word I'm searching for? Oh yeah, a risk, which means corporate bonds are priced relative to treasuries based on their risk of default. Apparently you think the market cannot price risk unless it follows a normal distribution is your other point?

I think I'm just getting trolled at this point.
Quite the contrary, I have said risk can be skewed. But the market cannot price in risk truly because no one agrees as to what risks are worth receiving a premium or paying one.

I am not trolling either; I merely have a radically different opinion about risk. And it is congruent with EMH.
Last edited by secondopinion on Mon May 29, 2023 2:43 pm, edited 4 times in total.
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by rkhusky »

burritoLover wrote: Mon May 29, 2023 7:23 am
rkhusky wrote: Sun May 28, 2023 6:08 pm
burritoLover wrote: Sun May 28, 2023 9:11 am Not all risk is the same. Some risk is compensated for, other risks are not. You can mitigate the idiosyncratic risk (which you are not compensated for) of an individual stock by adding more stocks to the portfolio. You cannot diversify away systemic risk (that which you are compensated for). For example, you can't diversify in a way that you can have an all-stock portfolio that has stock-like returns with bond-like volatility.
So, is the risk in small caps compensated? For example, can you diversify the idiosyncratic risk of small caps by adding large caps?
That's the crux of the question. Is small cap blend dominated by risk that you are not compensated for (small cap growth "junk" with certain characteristics as has been proposed by factor supporters)? No one knows the answer for sure. I would argue, no, small cap investing is not dead and definitely not convincing from the perspective of comparing a high-fee advisor only fund after the Banz publication to the lowest-fee S&P 500 fund at the time that includes an incredible 10-ish year period where large cap growth absolutely dominated everything.
And where does that belief come from? It can’t come from the idea that small caps are riskier, because we don’t know whether any additional risk is actually compensated. So, I suggest the belief comes from believing past performance will continue into the future, and really ultimately has nothing to do with risk.

There was an observed period of out-performance of small caps in the past. And it was suggested that the reason was because small caps are riskier and investors were rewarded for taking extra risk. That’s been turned around and now people say that small caps are riskier, so they must provide higher returns in the future.
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by Marseille07 »

rkhusky wrote: Mon May 29, 2023 2:40 pm And where does that belief come from? It can’t come from the idea that small caps are riskier, because we don’t know whether any additional risk is actually compensated. So, I suggest the belief comes from believing past performance will continue into the future, and really has nothing to do with risk.

There was an observed period of out-performance of small caps in the past. And it was suggested that the reason was because small caps are riskier and investors were rewarded for taking extra risk. That’s been turned around and now people say that small caps are riskier, so they must provide higher returns in the future.
Right, and that's what I was trying to tell burritoLover. Just because SCV's volatility, MaxDD, best / worst year etc etc are wider don't mean risk was the source of return. And it's actually quite unhealthy to call SCG "poison" where the data doesn't fit their narrative. If they misunderstand the markets, they pay the price, although in this particular instance it is relatively harmless because factors don't matter a whole lot. But it is still misunderstanding nonetheless.
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by burritoLover »

I'll quote Ben Felix below - this is him explaining this concept to his Mom so should be accessible to everyone. This is not some radical (nor new) concept.
Ben Felix wrote:When a company earns profits, you as the investor you want to invest in that company so that you can partake in the profits. Now you buy a stock, you're buying a stream of profits in the future, because the company is earning profits now, but you also expected to earn profits in the future, which is why you're willing to pay money for it. You're buying the future profits. Now the discount rate, the thing that you asked about, the discount rate is the rate at which you discount those future profits to decide how much you're willing to pay for them today.
...
The reason the discount rate is important is because it reflects the amount of risk in the cash flows. A very low risk set of cash flows, like a very safe company, you would apply a low discount rate, because you're fairly certain you're going to get all of those future profits.
...
You're paying a bit more now to get more certain future cash flows. Whereas, it's a riskier stock with more uncertain future cash flows, you're going to say, “Well, for me to own this, I'm going to pay a lower price.” Therefore, ensuring you of a higher expected return. The riskier the investment, the higher the expected return. Otherwise, why would you invest in it?
https://rationalreminder.ca/podcast/64
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by Marseille07 »

burritoLover wrote: Mon May 29, 2023 2:52 pm I'll quote Ben Felix below - this is him explaining this concept to his Mom so should be accessible to everyone. This is not some radical (nor new) concept.
Ben Felix wrote:When a company earns profits, you as the investor you want to invest in that company so that you can partake in the profits. Now you buy a stock, you're buying a stream of profits in the future, because the company is earning profits now, but you also expected to earn profits in the future, which is why you're willing to pay money for it. You're buying the future profits. Now the discount rate, the thing that you asked about, the discount rate is the rate at which you discount those future profits to decide how much you're willing to pay for them today.
...
The reason the discount rate is important is because it reflects the amount of risk in the cash flows. A very low risk set of cash flows, like a very safe company, you would apply a low discount rate, because you're fairly certain you're going to get all of those future profits.
...
You're paying a bit more now to get more certain future cash flows. Whereas, it's a riskier stock with more uncertain future cash flows, you're going to say, “Well, for me to own this, I'm going to pay a lower price.” Therefore, ensuring you of a higher expected return. The riskier the investment, the higher the expected return. Otherwise, why would you invest in it?
https://rationalreminder.ca/podcast/64
Sure, if you are actually analyzing companies within SCV and decide to invest or not invest, I can see that viewpoint.

Do you make such decisions when you buy Avantis SCV? I don't think so. So no, Felix's take is *understandable* in some cases but not applicable to you and I, or the majority of investors out there.
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by burritoLover »

Marseille07 wrote: Mon May 29, 2023 2:58 pm
burritoLover wrote: Mon May 29, 2023 2:52 pm I'll quote Ben Felix below - this is him explaining this concept to his Mom so should be accessible to everyone. This is not some radical (nor new) concept.
Ben Felix wrote:When a company earns profits, you as the investor you want to invest in that company so that you can partake in the profits. Now you buy a stock, you're buying a stream of profits in the future, because the company is earning profits now, but you also expected to earn profits in the future, which is why you're willing to pay money for it. You're buying the future profits. Now the discount rate, the thing that you asked about, the discount rate is the rate at which you discount those future profits to decide how much you're willing to pay for them today.
...
The reason the discount rate is important is because it reflects the amount of risk in the cash flows. A very low risk set of cash flows, like a very safe company, you would apply a low discount rate, because you're fairly certain you're going to get all of those future profits.
...
You're paying a bit more now to get more certain future cash flows. Whereas, it's a riskier stock with more uncertain future cash flows, you're going to say, “Well, for me to own this, I'm going to pay a lower price.” Therefore, ensuring you of a higher expected return. The riskier the investment, the higher the expected return. Otherwise, why would you invest in it?
https://rationalreminder.ca/podcast/64
Sure, if you are actually analyzing companies within SCV and decide to invest or not invest, I can see that viewpoint.

Do you make such decisions when you buy Avantis SCV? I don't think so. So no, Felix's take is *understandable* in some cases but not applicable to you and I, or the majority of investors out there.
Remember, we were talking about risks that are compensated for and how risk plays a role in pricing individual securities. But, at this point, we've gone off the reservation a bit. Curious if professor McQ has any thoughts - this is their thread after all.
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by SimpleGift »

nedsaid wrote: Sun May 28, 2023 10:34 am The Morningstar article from a ways back mentioned specifically that a screening for companies that have earnings caused the Small-Cap premium to return with a vengeance. They used the S&P 600 Small-Cap Index as an example of this. Can't remember if they mentioned the Quality factor.
Looking more closely at the outperformance of Vanguard’s S&P Small Cap 600 Fund (Tax-Managed) since its inception in 1999, it appears that most of this lifetime outperformance was achieved during the Tech Crash in 2000, and in the years immediately following (chart below). Which make sense, since any company that was showing stable earnings and profitability (i.e., quality) during this period was attractive to investors.

Image
Source: PV

Since that time, the performance of S&P’s Small Cap 600 Index, Vanguard’s Small Cap Index and its S&P 500 Fund appears to have been pretty much the same.
Last edited by SimpleGift on Mon May 29, 2023 3:48 pm, edited 2 times in total.
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by McQ »

burritoLover wrote: Mon May 29, 2023 3:06 pm ...
Remember, we were talking about risks that are compensated for and how risk plays a role in pricing individual securities. But, at this point, we've gone off the reservation a bit. Curious if professor McQ has any thoughts - this is their thread after all.
Indeed, I was at the point of asking LadyGeek to port the exchange between you and marseille7 into its own thread, under a title something like, "How is risk priced in the market (and when is it not)? Certainly an appropriate topic for the forum, but somewhat far afield from this thread, which is focused on what mutual fund investors got (or didn't) from the smallcap effect (which certainly exists in theoretical calculations).

Perhaps my next post will help steer things back. [burritoLover, it's somewhat responsive to your Friday pm post].
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by McQ »

Svensk Anga wrote: Fri May 26, 2023 9:03 am
rkhusky wrote: Fri May 26, 2023 6:26 am One can see in the plots that sometimes SC outperforms LC and sometimes LC outperforms SC, so any overall outperformance depends on the endpoints of the time period. Perhaps it will continue that way into the future. Or not. Added risk in the stock market is no guarantee of added return.
The back-and-forth in returns leadership also suggests that there was a rebalancing bonus to be had, provided one was wise to the effect and disciplined enough to implement it through the years.
Thanks for raising that possibility. I took a look.

I assumed an 80/20 split with annual rebalancing over the 41 years. As you can see on the chart below (you may have to squint a bit), the gray line showing the rebalanced portfolio does in the end outperform both the S&P fund and the DFA Microcap fund.

Image

Rebalancing provides just over a dozen basis points in incremental return, at 11.47% annualized. But it took a long time for this victory to be achieved. Again, you will really have to squint, but through 2018, the first 37 years, the blend had returned less than the best-performing of its two components. You had to wait four more years to see the rebalancing bonus.

If you recall my Markowitz thread (viewtopic.php?t=397584), a dozen bp is pretty much the level of diversification benefit you would expect from a lop-sided weighting of two risk assets, which happen to be correlated at .74 over this period (the SBBI has the large-small correlation as .79 over the entire 1926 – 2019 period, so no big deviation in this stretch).

If an investor is disappointed with that dozen bp incremental return for rebalancing, they might want to rethink their rationale for engaging in a 20% factor tilt—or their assessment of the potential benefit of diversification across risk assets.
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by burritoLover »

McQ wrote: Mon May 29, 2023 3:36 pm
burritoLover wrote: Mon May 29, 2023 3:06 pm ...
Remember, we were talking about risks that are compensated for and how risk plays a role in pricing individual securities. But, at this point, we've gone off the reservation a bit. Curious if professor McQ has any thoughts - this is their thread after all.
Indeed, I was at the point of asking LadyGeek to port the exchange between you and marseille7 into its own thread, under a title something like, "How is risk priced in the market (and when is it not)? Certainly an appropriate topic for the forum, but somewhat far afield from this thread, which is focused on what mutual fund investors got (or didn't) from the smallcap effect (which certainly exists in theoretical calculations).

Perhaps my next post will help steer things back. [burritoLover, it's somewhat responsive to your Friday pm post].
Sorry about that!
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Re: How Much of the Smallcap Effect Could Mutual Fund Investors Have Got?

Post by nisiprius »

Long-term comparisons between two portfolios often involve leapfrogging, with one fund alternately leaping and lagging the other. The leaps often last five, ten, fifteen or more years. The total for a time period, even a long time period, is endpoint sensitive, and which portfolio outperforms depends on whether the time period caught two leaps and one lag or two lags and one leap, etc. The total for very long time periods typically involves a difference that look small when CAGRs are compared, but large when dollars are compared.

There don't seem to be generally-accepted robust tools for determining if the difference is "significant."

There is a psychological test, but unfortunately it's hard to perform and involves concealing information from the subject, or even deceiving them. The test is to show them the performance comparison without their knowing the nature of the portfolios. Or, to be deceptive, claiming that the underperforming fund was passive and the outperforming fund is active. Ask the subject to imagine that they hold the underperforming fund and ask if the outperformance of the other fund is large enough, consistent enough, and robust enough to induce them to switch.

I did something like this in 2011, in a thread originally and falsely titled An imaginary active fund: good enough to make you switch?
nisiprius wrote: Sat Oct 01, 2011 5:57 amHere's the trick. It's really about small-cap tilting, not active management. Portfolio A is 60/40 large-cap stocks and bonds. Portfolio B is one with a small-cap tilt that has had bond allocation increased to give it exactly the same standard deviation as A. The dishonest thing I did was to poison everyone against portfolio B by calling it "active."

I wanted to see if the merits of the small-cap tilt are large enough and convincing enough to overcome the prejudice I created. And I wanted to show the very-long-term 0.33% benefit within the context of two-decade-long periods of 1%, 2% performance differences.

As i write this, the poll results stand at:

Yes, $13.8 million instead of $10.9 million speaks for itself: 1
No, 9.58% average annual return isn't that much more than 9.25% to be convincing: 7
Yes, for some other reason: 0
No, for some other reason: 10
I can't answer honestly because I see through your trick: 3
Other: 1
(This comes from the days before the forum disabled the "poll" feature. The data were the SBBI large-company, small-company, and intermediate-term government bond series. Regrettably, the image hosting service I used then vanished, the images were lost, and I didn't keep backups).

The relevance here is that people did not think the difference created by a small-cap tilt was enough to justify switching--if they were falsely told that the difference was created by active management.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.
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