The latest podcast has been uploaded onto the website - 3 Factor Model
The following provides a transcript of the podcast:
Welcome to the latest edition of Monday's Money Minute. In today's edition I want to provide a quick review of the three factor model which is the approach this firm uses to assist clients structure their Australian and international share exposures.
Research published by professors Fama & French in the 1990s suggested that on top of the expected higher returns, compared to risk free assets, from investing in shares there were two other areas of the equity market that seemed to provide even slightly higher returns over the long term. Namely investing in
- small companies and
- value style companies
The key reason behind this outcome becomes clearer through an understanding of risk for investors. Investors expect higher returns for investing in riskier investments otherwise they would not bother. Investing in companies on the share market is a risky activity. Companies don't tend to smoothly grow over time and some end up failing leaving their investors with very little from an initial investment.
Therefore, to invest in companies investors need to expect to get a better return than from plonking their savings in a much more secure cash account. If you look at share market returns at the end of a really sharp fall like we have experienced to the beginning of March this year, this principle (and our definition of long term) is put to the test. However, over the very long term, most would agree with the assertion that investing in shares has provided a better outcome compared to investing in risk free assets such as cash and government bonds.
Smaller companies are riskier options compared to large well established companies and therefore investors in this area of the market expect a higher return going forward. Because they are riskier, this higher return is not always achieved. This is what makes it a risk - the lack of certainty.
Value companies, as defined in Fama & French's research as those companies where their book assets seem to have been undervalued by the market, as identified through using a Book to Market ratio, also hold more risk for an investor as compared to investing in companies the market are more positive about.
Fama & French's research suggested that investors could look to achieve 2 to 3 % better returns from investing in these small and value areas of the market.
So how have these areas performed over 2008?
For the 12 months to the end of December 2008, we saw that:
An investment in Australian large companies fell in value by approximately 37%
Australian small companies by approximately 48%,
Australian value companies by approximately 33%
So small companies performed a lot worse and value companies slightly better.
An investment in Global large companies fell in value by approximately 24%
Global small companies by approximately 24%,
Global value companies by approximately 31%
Here, the opposite to the Australia market was experienced, value underperformed and small performed in line.
2008 clearly showed that the premiums can not be relied upon to consistently be there each and every period of time. It is all about risk and uncertainty.
So what has happened since the beginning of 2009?
An investment in Australian large companies has risen in value by approximately 3%
Australian small companies risen by approximately 17%,
Australian value companies risen by approximately 3%
An investment in Global large companies has fallen in value by approximately 7%
Global small companies fallen by approximately 5%,
Global value companies fallen by approximately 4%
2009 so far has been a much better year for the factors especially Australian small.
What about longer term results?
For the 7 years the end of April 2009:
Australian small companies have outperformed large companies by approximately 3.5%
Value companies have outperformed large companies by just on 2%
Global small companies have outperformed lglobal arge companies by approximately 4%
Global value companies have outperformed large companies by just on 2%
Part of the risk/reward story in international markets I have left out until now is the Emerging Markets story. The story here is that investing in developing countries like China, India, Brazil is a riskier proposition due to a range of political and economic factors. However the expected return should also be higher but more volatile. The recent results for this area of the market have highlighted these points:
Through 2008 - the emerging markets investment I suggest clients use fell by 36% - 12% worse than global large companies
2009 Year to Date - this investment is up 18%, a 25% better performance compared to global large companies.
For the past 7 years - approximately a 12% better performance compared to global large companies.
In conclusion, structuring investments to add exposure to small, value and emerging market companies is not a free ride as we saw through 2008. For those who build investment portfolios with a long term focus utilising an index style approach, the benefits will come not only from the risk story but also from diversification benefits.
If you would like to find out more about this firm's approach to structuring portfolios please take a look at our Building Portfolios page on our website or get in contact via email.