John Cochrane is professor of finance at the Booth School of Business at the University of Chicago and is an expert on the theory of asset pricing. You can take (or audit) his free online course through Coursera. In this course he starts out by briefly summarizing the state of the art in asset management back in the 1970s. The key ideas at the time were Modern Portfolio Theory (MPT), the Capital Asset Pricing Model (CAPM) and the Efficient Markets Hypothesis (EMH). The main authors of these theories were all awarded Nobel Prizes in economics. Basically, the MPT showed that you could reduce risk by diversifying across multiple investment vehicles, the CAPM argued that you only got paid for taking on “systematic” or market risk, and the EMH argued that market prices reflect all available information. The combination of these ideas argued strongly for investing in two assets: a risk-free asset (the closest thing to this in the real world is probably inflation-indexed Treasury bonds) and a “market” portfolio that includes all stocks in proportion to their individual market values. These theories provided intellectual support for John Bogle’s introduction of the first index fund, the Vanguard 500, as discussed in a previous blog.

Recent Research

Since the 1970s a lot has changed.   First, the CAPM has not stood up to testing. In the CAPM, the expected return on an asset (an individual stock, or a portfolio of stocks) is a positive function of the “beta” of the asset, which is a measure of the sensitivity of the asset’s return relative to the return on the market portfolio (the source of “systematic” risk). Thus “beta” has come to mean the return from taking on market risk. Any realized return above the predicted return is called “alpha” and represents non-systematic return. The theory is that alpha should be zero on average. However, in exhaustive tests conducted in the 1980s and 1990s it was discovered that certain classes of stocks, in particular “small” stocks and “value” stocks tended to have returns greater than you would have expected from their betas (that is, they exhibited positive alpha).

Value stocks mean stocks that have depressed prices relative to earnings, dividends or book value. Thus, the ratio of earnings to price or dividend to price is high for a value stock. The fact that value stocks seem to do better than growth stocks prompted people to contemplate predicting future return by using these ratios. In particular, Cochrane discusses at length a model that explains return simply by using the dividend yield (ratio of dividend to price, or D/P). He finds that this model “works” well – high D/P predicts high return and low D/P predicts low return, particularly over relatively long horizons (like five years or so). In other words, long-term equity returns are (at least somewhat) predictable!

And not just stock market returns. Studies have also shown that bond returns are predictable (extremely steep yield curves predict higher returns for longer term bonds), foreign exchange returns are predictable (extremely high interest rates on a particular currency predict higher returns on a strategy that is long the currency with high rates and short the currency with low rates), and similarly for credit markets and commodity markets. To summarize this research, researchers now believe that there are numerous sources of excess return or “risk premiums” including the overall equity risk premium, the value stock premium, the small stock premium, the term premium, the credit premium, and so on.

Implications for Portfolio Management

In order to determine if you should orient your portfolio so as to bet on these various sources of excess return, you have to make a judgment about why they exist in the historical data, and whether they are likely to persist in the future. Those authors that continue to support the EMH, like its chief creator Chicago Business School professor Eugene Fama, argue that the value, size and other effects are reflections of underlying deeper sources of risk. Other economists, like Yale economist Robert Shiller, argue that findings of positive risk premiums suggest that the markets are not efficient, perhaps because investors are not totally rational. It is interesting to note that Fama and Shiller (along with another Chicago finance professor Lars Hansen) shared the 2014 Nobel Prize in Economics, even though they come down on opposite sides of this major issue.

If Fama is correct then it is likely that risk premiums will persist, but you are indeed taking on greater risk. If Shiller is correct, the historical excess return has been a “free lunch”, but who knows if it will continue.   Notwithstanding this debate, many investment management companies have sprung up over the past two decades based on the academic research mentioned above. Once of these is Dimensional Funds Advisors (DFA) founded in 1981 by Chicago Business School alum David Booth. DFA offers a number of investment funds that are constructed so as to capture the size effect, the value effect, the term effect, the credit effect, and so on. DFA has been quite successful (so much so that business school at Chicago is now known as the Booth School in honor of his significant financial contribution).

Should you invest in DFA funds instead of Vanguard? Well, you can’t, at least not easily. DFA only sells its funds through selected investment advisors. You have to sign up with one of the approved investment advisors and pay their fee plus the DFA fee. The question then becomes, once you pay the double set of fees, have you lost the benefit of low cost passively managed funds?

Meanwhile, the vendors of passively managed index funds (like Vanguard) have responded to the new research by offering passive funds that “tilt” toward small stocks (ticker symbol VB), or value stocks (VTV), or other possible sources of excess return. Indeed, these are the types of funds that comprise the “Gone Fishing” portfolio described in a previous posting.

While it makes sense to me that stock prices (and other asset prices) are subject to psychological waves of optimism and pessimism, I think Fama’s idea that there are other sources of risk besides correlation with the market portfolio also makes sense. One “deeper” source of risk may simply be the probability of failure. Small stocks are more likely to fail in a tough economic scenario due to less staying power. Likewise for value stocks (an operational definition of “value” is where the price is “low” relative to earnings, dividends or book value). Thus, the additional return for investing in small stocks or value stocks is associated with additional risk. Alternatively, you could achieve higher expected return simply by increasing your allocation to the overall stock market.

Careful analysis by scholars and quantitative fund managers suggests that it may be more “efficient” to seek greater risk by diversifying into value or size (or other potential areas of greater risk and return like term, credit, carry, liquidity, etc.), instead of simply increasing the overall equity allocation. Indeed, a common strategy for quantitative hedge funds is to “optimize” their portfolios by allocating risk to various areas until the marginal additional return per unit risk is the same in each area. The expertise and analysis required to do this effectively comes with a high price (giant hedge fund fees) and may or may not provide a net benefit after fees. Data suggests that the after-fee gain is small or negative.

It is not feasible for the individual investor to follow this hedge fund strategy. But the “do-it-yourself” investor does have a number of feasible ways to go. You can use the Bogle recommended two fund strategy (one overall stock fund and one overall bond fund). You can use the ten fund Gone Fishing strategy (which is partially based on the academic findings discussed above). Either way, you will achieve net returns close to overall market returns, which is dramatically better than the historical performance of individual investors.

Still, lots of people (perhaps a majority) are not comfortable with going it alone and would prefer to seek expert guidance. Unfortunately, this expertise generally comes at a high cost. Recently, another alternative has appeared on the scene. This is the “robo-advisor” where financial theory and technology link up to offer a managed fund process at very low cost. In the next posting, I’ll profile one of these services; a very successful recent IPO (i.e., a company that recently sold stock to the public for the first time) called Wealth Front.