Fisher looked across 1,000 different rolling 10-year periods over the last 90 years, noting that small-cap value strategies still outperform large-cap growth 87 percent of the time, but the return premium for the size and value factors is cyclical over time and depends on the market environment.
Over the past two decades, the annualized 10-year, small-cap value premium swung between positive 15 percent and negative 5 percent, according to Fisher, which means that the factors are most likely currently in a temporary stretch of negativity.
“Empiricaly, this would appear to be a reversion to the mean story. We’re in the 13 percent of the time that small-cap value deosn’t do better,” says Fisher.
Fisher found that investor patience is key to making the size and value factors work: The longer the time period studied, the more likely small-cap and value strategies outperform. Based on nine decades of market data, tilting a stock portfolio towards smaller capitalization and less expensive stocks over the longest possible timeframe still produces significant outperformance.
Fisher also asked whether a different market scenario could “break” factor cyclicality, noting that “historical data alone isn’t enough to build an investment strategy.” In recent years, some market strategists have suggested that the rise of passive and hands-off investing in market-capitalization weighted index funds is distorting the market and breaking the link between risk and return.
“The popularity of indexing might be programmatically causing the momentum premium in the market to be an even bigger deal,” says Fisher. “Along the way, rising prices attract more capital, which causes prices to rise even further, which attracts still more capital and even higher prices. I think most of us are reasonable enough to understand that that movie has to end at some point in time. Eventually, investors will stand up and say that they don’t think their portfolios should have companies with stocks trading at 500-times earnings.”
Value investing still links perceptions of risk to higher returns, says Fisher. Old, slowly growing industrial firms with high costs must offer higher returns than large, healthy, quickly growing technology firms with higher valuations, or investor capital will avoid the old and flock to the new. Market participants still over- and under-react to headlines, mispricing equities and creating opportunities for value investors, says Fisher. As bull markets age, investor appetite for high valuation stocks increases, opening up more opportunities to access value.
The potential outperformance offered by small-cap investing is also still connected to additional risk, as information about smaller companies still moves more slowly and is accessed by fewer people than information about larger companies. Small companies generally carry smaller cash reserves and conduct less-diversified business operations, making them inherently riskier investments compared to larger companies. Fisher argues that the principles behind small-cap investing still hold.
“Statistically, there really isn’t evidence that the world has changed. Risk and reward are still related,” says Fisher.
Even if value and size strategies render no opportunities for higher returns moving forward, Fisher argues that there’s still a diversification benefit to be had in accessing the strategies and rebalancing between core benchmarks and value- or size-based indexes. When Fisher rebalanced between 25 percent small-value and 75 percent large-growth strategies in a portfolio between July 1, 2012, and June 30, 2017, he produced risk-adjusted returns similar to an all large-cap growth strategy while maintaining some exposure to the size and value factors.