You Want the Size, Value, and Profitability Premiums … But How?


KEY TAKEAWAYS
  • Capturing the size, value, and profitability premiums in real-world portfolios requires expertise.

  • Investors should be cautious about favoring one premium over another or one region over another based on the magnitude of the expected premiums.

  • The integrated core approach, which accounts for the interactions among multiple premiums and maintains a strong tie between security weights and market prices, can lead to more reliable outperformance, better risk control, and lower costs.

You have made the decision to target the size, value, and profitability premiums in equities, which is great, but it is only a great starting point. There are many questions to consider when incorporating these premiums into real-world asset allocations. How to allocate across premiums and regions? Is it better to get exposure to the premiums through a combination of single factor portfolios, a market-satellite combination, or an integrated solution? What type of weighting scheme should you use? We address these questions in a series of recent papers.

In “Assessing the Relative Magnitude of Premiums” we evaluate whether the size, value, and profitability premiums differ in magnitude across regions. Using various statistical tests, our study shows no reliable differences in the expected premiums, either individually or jointly, across US, developed ex US, and emerging markets. We then examine whether the premiums vary across dimensions: Is the size premium reliably different from the value premium? Is the value premium reliably different from the profitability premium? The tests do not show reliable differences across premiums within any region or globally. Therefore, while it may be sensible to adjust your allocation across premiums and regions to meet your investment goals and constraints, think twice before favoring one premium over another or one region over another based on the magnitude of the expected premiums.

Once the overall allocation is determined, what portfolios should you use to get to the desired exposures? You have at least a few options: combining the market portfolio with single factor portfolios, combining the market portfolio with a satellite multifactor portfolio, or using an integrated core portfolio that simultaneously targets the size, value, and profitability premiums across the entire market. We compare these approaches in “Pursuing Multiple Premiums: Combination vs. Integration.” Our results show that the integrated core approach can better account for the interactions among multiple premiums and lead to more reliable outperformance, better risk control, and lower costs. These benefits can be critical to an efficient pursuit of multiple premiums and cannot be replicated through combination approaches.

Another important decision you face is how to weigh individual stocks in systematic portfolios. Our paper “Weighting for the Right One: Weighting Scheme Design for Systematic Equity Portfolios” compares eight frequently used weighting schemes and highlights the aspects of weighting scheme design that deserve your attention. Perhaps most importantly, you want to see a close link between security weights and market prices. Ignoring prices, as in the cases of equal weighting, rank weighting, z-score weighting, and inverse volatility weighting, can result in uncontrolled overweights in the smallest names, which in turn can lead to significant underweights in the biggest names. More concretely, you might end up overweighting some small cap names by 50 or even 100 times their market cap weights while holding the largest stocks, like Apple, at a few basis points. While such extreme deviations from market weights can produce shining performance on paper, the performance is unlikely to survive the excessive turnover and trading costs in the real world. Using a price-based weighting scheme can effectively mitigate these issues, but there is more to designing a robust weighting scheme. Among the various price-based weighting schemes, our analysis identifies the integrated core approach as the most effective at integrating multiple premiums, managing risks and costs, and accounting for different investor objectives and practical considerations.

So it is great that you have decided to target the size, value, and profitability premiums in your equity allocation. The next, and equally important, decision is to choose the right way to go about it. After all, factors by themselves are not investment strategies. As Nobel laureate Myron Scholes once said, “Ideas alone are cheap—implementation is what really counts.”



Read on SSRN


Glossary

Basis point: One basis point equals 0.01%.

Equal weighting: A weighting scheme that holds all firms at the same weight. 

Inverse volatility weighting: A weighting scheme that weights firms in proportion to the inverse of their return volatility.

Market-satellite combination: An approach to pursuing multiple premiums by combining the market portfolio with a single strategy that focuses on the intersection of stocks with high expected returns across multiple premiums.

Price-based weighting: Weighting schemes that maintain the link between security weights and market prices. 

Profitability premium: The return difference between stocks of companies with high profitability vs. those with low profitability.

Rank weighting: A weighting scheme that weights firms in proportion to their ranks based on sorts on their market capitalization, relative price, and profitability. 

Single factor portfolio: A strategy focused on one single premium. 

Size premium: The return difference between small capitalization stocks and large capitalization stocks.

Value premium: The return difference between stocks with low relative prices (value) and stocks with high relative prices (growth).

Z-score weighting: A weighting scheme that weights firms based on their market capitalization, relative price, and profitability z-scores. Z-score is calculated as a characteristic’s raw value minus its cross-sectional average, divided by its cross-sectional standard deviation.

Disclosures

This information should not be considered a recommendation to buy or sell a particular security. Named securities may be held in accounts managed by Dimensional. The securities identified do not represent all securities purchased or sold for client accounts. It should not be assumed that an investment in the securities identified was or would be profitable.

The information in this document is provided in good faith without any warranty and is intended for the recipient’s background information only. It does not constitute investment advice, recommendation, or an offer of any services or products for sale and is not intended to provide a sufficient basis on which to make an investment decision. It is the responsibility of any persons wishing to make a purchase to inform themselves of and observe all applicable laws and regulations. Unauthorized copying, reproducing, duplicating, or transmitting of this document are strictly prohibited. Dimensional accepts no responsibility for loss arising from the use of the information contained herein.

“Dimensional” refers to the Dimensional separate but affiliated entities generally, rather than to one particular entity. These entities are Dimensional Fund Advisors LP, Dimensional Fund Advisors Ltd., Dimensional Ireland Limited, DFA Australia Limited, Dimensional Fund Advisors Canada ULC, Dimensional Fund Advisors Pte. Ltd., Dimensional Japan Ltd., and Dimensional Hong Kong Limited. Dimensional Hong Kong Limited is licensed by the Securities and Futures Commission to conduct Type 1 (dealing in securities) regulated activities only and does not provide asset management services.

UNITED STATES: Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.

Investment products: • Not FDIC Insured • Not Bank Guaranteed • May Lose Value
Dimensional Fund Advisors does not have any bank affiliates.

CANADA: These materials have been prepared by Dimensional Fund Advisors Canada ULC. They are provided for educational purposes only, should not be construed as investment advice or an offer of any security for sale and do not represent a recommendation of any particular security, strategy or investment product. Commissions, trailing commissions, management fees, and expenses all may be associated with mutual fund investments. Unless otherwise noted, any indicated total rates of return reflect the historical annual compounded total returns, including changes in share or unit value and reinvestment of all dividends or other distributions, and do not take into account sales, redemption, distribution, or optional charges or income taxes payable by any security holder that would have reduced returns. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently, and past performance may not be repeated.

AUSTRALIA and NEW ZEALAND: This material is issued by DFA Australia Limited (AFS License No. 238093, ABN 46 065 937 671). This material is provided for information only. No account has been taken of the objectives, financial situation or needs of any particular person. Accordingly, to the extent this material constitutes general financial product advice, investors should, before acting on the advice, consider the appropriateness of the advice, having regard to the investor’s objectives, financial situation and needs. Investors should also consider the Product Disclosure Statement (PDS) and the target market determination (TMD) that has been made for each financial product either issued or distributed by DFA Australia Limited prior to acquiring or continuing to hold any investment. Go to au.dimensional.com/funds to access a copy of the PDS or the relevant TMD. Any opinions expressed in this material reflect our judgement at the date of publication and are subject to change.

WHERE ISSUED BY DIMENSIONAL IRELAND LIMITED OR DIMENSIONAL FUND ADVISORS LTD.
Neither Dimensional Ireland Limited (Dimensional Ireland) nor Dimensional Fund Advisors Ltd. (Dimensional UK), as applicable (each an “Issuing Entity,” as the context requires), give financial advice. You are responsible for deciding whether an investment is suitable for your personal circumstances, and we recommend that a financial adviser helps you with that decision.

NOTICE TO INVESTORS IN SWITZERLAND: This is an advertising document.

WHERE ISSUED BY DIMENSIONAL IRELAND LIMITED
Issued by Dimensional Ireland Limited (Dimensional Ireland), with registered office 10 Earlsfort Terrace, Dublin 2, D02 T380, Ireland. Dimensional Ireland is regulated by the Central Bank of Ireland (Registration No. C185067). Information and opinions presented in this material have been obtained or derived from sources believed by Dimensional Ireland to be reliable, and Dimensional Ireland has reasonable grounds to believe that all factual information herein is true as at the date of this document.

Dimensional Ireland issues information and materials in English and may also issue information and materials in certain other languages. The recipient’s continued acceptance of information and materials from Dimensional Ireland will constitute the recipient’s consent to be provided with such information and materials, where relevant, in more than one language.

WHERE ISSUED BY DIMENSIONAL FUND ADVISORS LTD.
Issued by Dimensional Fund Advisors Ltd. (Dimensional UK), 20 Triton Street, Regent’s Place, London, NW1 3BF. Dimensional UK is authorised and regulated by the Financial Conduct Authority (FCA). Information and opinions presented in this material have been obtained or derived from sources believed by Dimensional UK to be reliable, and Dimensional UK has reasonable grounds to believe that all factual information herein is true as at the date of this document.

Dimensional UK issues information and materials in English and may also issue information and materials in certain other languages. The recipient’s continued acceptance of information and materials from Dimensional UK will constitute the recipient’s consent to be provided with such information and materials, where relevant, in more than one language.

RISKS
Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. Past performance is not a guarantee of future results. There is no guarantee strategies will be successful.

JAPAN: Provided for institutional investors only. This document is deemed to be issued by Dimensional Japan Ltd., which is regulated by the Financial Services Agency of Japan and is registered as a Financial Instruments Firm conducting Investment Management Business and Investment Advisory and Agency Business. This material is solely for informational purposes only and shall not constitute an offer to sell or the solicitation to buy securities or enter into investment advisory contracts. The material in this article and any content contained herein may not be reproduced, copied, modified, transferred, disclosed, or used in any way not expressly permitted by Dimensional Japan Ltd. in writing. All expressions of opinion are subject to change without notice.

Dimensional Japan Ltd.
Director of Kanto Local Finance Bureau (FIBO) No. 2683
Membership: Japan Investment Advisers Association

FOR PROFESSIONAL INVESTORS IN HONG KONG.
This material is deemed to be issued by Dimensional Hong Kong Limited (CE No. BJE760) (“Dimensional Hong Kong”), which is licensed by the Securities and Futures Commission to conduct Type 1 (dealing in securities) regulated activities only and does not provide asset management services.

This material should only be provided to “professional investors” (as defined in the Securities and Futures Ordinance [Chapter 571 of the Laws of Hong Kong] and its subsidiary legislation) and is not for use with the public. This material is not directed to any person in any jurisdiction where (by reason of that person’s nationality, residence, or otherwise) the publication or availability of this material are prohibited or which would subject Dimensional Hong Kong (including its affiliates) or any of Dimensional Hong Kong’s products or services to any registration, licensing, or other such legal requirements within such jurisdiction or country. When provided to prospective investors, this material forms part of, and must be provided together with, applicable fund offering materials. This material must not be provided to prospective investors on a standalone basis. Before acting on any information in this material, you should consider whether it is suitable for your particular circumstances and, if appropriate, seek professional advice.

Unauthorized copying, reproducing, duplicating, or transmitting of this material are prohibited. This material and the distribution of this material are not intended to constitute and do not constitute an offer or an invitation to offer to the Hong Kong public to acquire, dispose of, subscribe for, or underwrite any securities, structured products, or related financial products or instruments nor investment advice thereto. Any opinions and views expressed herein are subject to change. Neither Dimensional Hong Kong nor its affiliates shall be responsible or held responsible for any content prepared by financial advisors. Financial advisors in Hong Kong shall not actively market the services of Dimensional Hong Kong or its affiliates to the Hong Kong public.

SINGAPORE
This material is deemed to be issued by Dimensional Fund Advisors Pte. Ltd., which is regulated by the Monetary Authority of Singapore and holds a capital markets services license for fund management.

This advertisement has not been reviewed by the Monetary Authority of Singapore. This information should not be considered investment advice or an offer of any security for sale. All information is given in good faith without any warranty and is not intended to provide professional, investment, or any other type of advice or recommendation and does not take into account the particular investment objectives, financial situation, or needs of individual recipients. Before acting on any information in this material, you should consider whether it is suitable for your particular circumstances and, if appropriate, seek professional advice. Dimensional Fund Advisors Pte. Ltd. does not accept any responsibility and cannot be held liable for any person’s use of or reliance on the information and opinions contained herein. Neither Dimensional Fund Advisors Pte. Ltd. nor its affiliates shall be responsible or held responsible for any content prepared by financial advisors.