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Why the return premiums flatter to deceive

I have written a great deal on the return premiums [1] – styling them as the superheroes of passive investing with the potential to kick the ass of the market.

The problem is, like all superheroes the return premiums have a dark side – tragic flaws that cause them to underperform or even fail to show up just when you need them most.

Consider this an anti-hero article designed to show just how much Kryptonite there is out there that can transform the passive investing equivalent of a comic book fantasy into just another chump in pants.

Looks good on paper

On paper, the best of the return premiums (also known as risk factors) have been shown to deliver market-beating returns of 4% per year [2].

That’s Mr Fantastic. But it’s not possible in the real world that you and I live in.

Why?

Because those returns are generated in academic simulations that:

The academics aren’t really cheating – at least not in the way that car makers cook up amazing fuel efficiency stats by testing their cars in labs rather than on roads and by removing wing mirrors and sealing up the door cracks.

The disconnect occurs because academic interest lies in understanding financial theory rather than producing practical products. (They can get hired for that later!)

Why funds fail to capture the full return premium [3]

The long and the short of it

The return premiums identified by academics are delivered by long-short portfolios. These theoretical portfolios buy equities with positive characteristics and short-sell [4] those with negative features.

For example, the value premium [5] can be defined as the annual average return on equities with high book-market ratios [6] minus the annual average return on equities with low book-market ratios.

The problem is that UK investors can only buy trackers that invest in long-only portfolios.

As a general rule of thumb, you can assume that such a long-only approach will only capture 50% of the premium1 [7].

So our hoped-for premium is cut in half at a stroke:

4% x 0.5 = 2%

Your real world fund also comes with costs that don’t trouble Ivory Tower boffins. A factor-based tracker might charge you anywhere from 0.3% to 0.8% a year, and this too must be deducted from a premium’s theoretical returns.

2% – 0.5% = 1.5% left of our premium.

Higher costs are common to factor-based trackers because capturing a premium may require a high turnover [8] of holdings (for example in the case of momentum [9]) or investing in small and illiquid securities (in the case of the size premium [10]) that are saddled with higher spreads [11].

Worst still, the bulk of a premium may exist in equities that are ill-served by commercially available products.

For example, there’s evidence [12] that large value US equities only beat the S&P 500 by 0.5% a year, whereas small value trounced it by 3.8% a year. Yet many value funds are concentrated in large value equities meaning that your factor fund may only collect the merest smidgeon of the premium.

0.5% x 0.5 (long only loss) – 0.2 (cost of large value fund over a regular large cap fund) = a miserable 0.05% left of the premium.

It’s scarcely worth the bother.

The size premium is particularly susceptible to hollowing out, given the Wild West that exists in small cap definitions.

MorningStar’s fund compare tool [13] can help you spot the difference and find out what you’re actually buying into.

No more heroes anymore

The final return premium hazard to watch out for is essentially one of self-harm.

The very emergence of mass-market funds – enabling us to buy into a premium – can flood the space with cash, raise valuations, and lead to low future returns as assets become overpriced.

Rick Ferri, for example, now advises investors to expect a future return [14] on the small value premium of just 1%.

That’s a note of caution you’d do well to extend to other return premiums like profitability [15] and momentum.

Indeed, the paper Does Academic Research Destroy Stock Return Predictability? [16] estimates that returns decline by 35% on average once a market anomaly is ‘discovered’.

So by all means pursue the premium path if you fancy a crack at outsized returns, but be aware that their superpowers might have waned.

Expect George Clooney Batman as opposed to Christian Bale Batman and you stand less chance of disappointment.

Take it steady,

The Accumulator

  1. The reality is more nuanced, depending on the premium, as this paper explains [19]. [ [20]]