Asset class investing

Everything this we have said so far suggests that if you believe in index investing, you should hold the broadest indices possible to try and hold the whole market. However Eugene Fama of the University of Chicago and Kenneth French of the Tuck School of Business at Dartmouth College have taken the CAPM model a step further.

After extensive research, they found that two factors relating to company size and whether the company is a ‘value’ or ‘growth’ stock, explain much of the variation in stock returns.  Both of these factors are related to risk.  They found that beta had little long term impact on the long term return of stocks.

Because they carry a higher level of risk, Fama and French conclude that financially less healthy ‘value’ companies have higher costs of capital (i.e. it costs more for them to borrow from the bank) than financially healthy ‘growth’ companies.  A company’s cost of capital is the investor’s expected return.

For example, since, from an investment point of view, Sainsbury is currently perceived as a riskier proposition than Tesco, investors should expect a higher return from Sainsbury than Tesco.

If Sainsbury had the same expected return as Tesco, no one would buy the shares.  The price of Sainsbury therefore falls to a point where its expected return exceeds that of Tesco.  Hence, it makes sense that ‘value’ or ‘under-performing’ companies are higher risk and therefore should have a higher return.  Similarly, as small companies present investors with higher risk over the long run, due to factors such as less security, and possibly weaker management and controls the returns are potentially higher.

Whilst the work of Fama and French shows that it is possible to increase the returns for investors by skewing portfolios with a value or small cap bias, this will result in some increase in risk.

Evolve has access to specialist index funds from Dimensional Fund Advisors that concentrate on ‘value’ stocks and small companies, that are not available to most retail investors. However, these will not be appropriate for everyone.