The Eggheads Did It Again
October 17, 2013
Richard Nixon called Adlai Stephenson an “egghead” during the 1952 presidential campaign. It was not meant as a compliment. Intellectuals, college professors and even the broader category of teachers just don’t get much respect in our society. I’m sure you have heard, and maybe even voiced, some disparaging remarks about these really smart people. “They live in their ivory towers, and could never make it in the dog-eat-dog world that the rest of us must survive in.” “They are pretentious, lack common sense, and are out of touch with the real world.” Finally, there is the ever popular witticism: “Those that can, do. Those that can’t, teach.”
Regardless of your opinion of academics, we here at Dixon Hughes Goodman Wealth Advisors love them. Well, maybe not all of them, but the ones who have found ways to add value to our investment process hold a particularly special place in our hearts. Of course, I am talking about those brainy folks at Dimensional Fund Advisors, who have developed the DFA funds that you own in your portfolios. Many people think DFA funds are just fancy index funds. If fancy means dramatically better investment vehicles, then feel free to describe them that way.
Over the years, DFA has found very interesting investment “factors” that add value to a portfolio. I’m sure you remember your DHGWA advisor enthusiastically describing the factors of size (small outperforms large) and value (low book-to-market stocks [value] outperform high book-to-market [growth] stocks). Those two factors have been very important in adding additional returns to our clients’ portfolios, especially when coupled with the Nobel Prize winning Modern Portfolio Theory asset class investment methodology.
Last year, DFA did massive amounts of research on an aspect of company performance that they believed would act as another performance-enhancing factor. They called this new factor “profitability,” and it dealt with a company’s ability to generate cash flows. How those cash flows compared to the company’s stock price determined whether it had high or low profitability. They found that high profitability companies typically continue to have future high profitability, while low profitability companies continued in that direction, as well.
The most interesting thing about this factor of profitability is that it can be measured and isolated in all asset classes. It worked the same with value and growth companies, large and small companies as well as domestic vs. international vs. emerging market companies. The profitability factor is a screen-able characteristic for all asset classes, which means the performance of all asset classes can be enhanced by using it. We are not talking about adding huge additional returns, but even modestly increasing an asset class’s returns could end up paying for a decent chunk of a client’s management fee. Check out the examples shown below.
As you can see, the above chart shows the returns of an asset class index fund in the second column, DFA’s returns on that same asset class in the third column, and DFA’s returns on that same asset class, plus the profitability screen in the fourth column. Notice how all asset classes – large, small, international and even emerging markets squeeze out additional return when the profitability factor screen is used. Sometimes the extra return is modest (.33% in the case of large cap value), and sometimes it is much greater (1.63% in the case of small cap). If one were to incorporate this profitability screen into their entire equity asset class holdings, imagine the additional long term increase in portfolio value that would occur.
That is precisely what DFA, and in turn your portfolio, will be doing. It will probably take several quarters to fully incorporate this new factor into most of your DFA equity asset class funds. The profitability factor will add no additional risk to the portfolio, but should add additional return. More return with no more risk is the perfect example of the “free lunch” methodology that Modern Portfolio Theory already adds to your investment experience.
So the next time you are considering saying something disparaging about someone in academia, just remember that certain members of that group are responsible for continuing to find ways in which to improve your financial life. Perhaps you will even start to use the term “egghead” as a compliment!
Third quarter equity asset class returns were generous, especially considering that this quarter has historically been the poorest performer of the four. There were changes in the relative performance of these equity asset classes, with many heretofore laggards charging ahead this quarter. For instance, all international asset classes outshined their US counterparts, interrupting a string of underperformance from earlier this year. Small Cap outperformed Large both domestically and internationally, and Core/Growth edged out Value. The biggest straggler has been Real Estate, which actually led the way during the 2011-2012 time period.
Never has there been a better example of Modern Portfolio Theory working in real time. Typical investor behaviors of changing allocations or jumping into the “hottest” asset class would have proven the exactly wrong move. These third quarter gains took place in a continuing atmosphere of modest economic growth. Employment is very slowly growing, but it pales to the typical gains seen in “normal” post-recession growth cycles. Corporate earnings growth continued their tepid pace. Strong home sales figures were probably the most robust aspect of the economy and a good harbinger of future growth. The fear of a rapid reduction of quantitative easing (QE2) that sent bond investors running for cover in the second quarter was quelled a bit when Ben Bernanke surprisingly reported in September that the Fed was not yet ready to put the brakes on the multiyear dampening of interest rates. Globally, stocks took this as good news, and rallied to yearly highs. Intermediate and long term bond prices will probably hold in a trading range until the Fed allows short term rates to find their “normal” level.
It would be foolish to assume these dramatic increases in equity prices will continue in a straight line. The normally positive fourth quarter may not be as friendly this year. Lastly, the childish behavior of our elected officials may prove to be a reason for some pullback in stocks. Who would have dreamt at the end of last year (remember the fiscal cliff?) that nine months later some equity asset classes would have returned 25%-30%? All these news items are merely white noise for a long term investor using Modern Portfolio Theory. We will remain disciplined, rebalance when necessary, and continue to use the most cost, performance and tax efficient investment vehicles we can find. That is the formula for successful investing, and we are delighted that you have chosen us to assist in your financial future and meeting your life’s objectives.
It will be interesting to see how the fourth quarter progresses. Will the dissention in Washington allow for a positive year end, especially in light of the third quarter market strength? Enjoy the holidays, spend quality time with your family, and we’ll communicate again in early January.
Frederick F. Kramer IV, JD
Chief Investment Officer
Dixon Hughes Goodman Wealth Advisors LLC