by: Richard A. Anderson
At HIGHLAND, one of the cornerstones of our investment approach is that securities offering higher expected returns share particular attributes, which we refer to as the dimensions of higher expected returns (or dimensions for short). These dimensions are based on economic theory, backed by Nobel Prize winning academic research, and supported by decades of real-world historical data. Dimensional Fund Advisors is an investment management firm with a long history of applying academic research to practical investing and is one of our preferred investment managers. Dimensional Fund Advisors defines a dimension as a return difference between two assets or portfolios “that is sensible, empirically robust in the data, and cost-effective to capture in well-diversified portfolios.”
We believe there are four dimensions of higher expected returns for equities, which are shown in the image below.
We expect the Market, Company Size, Relative Price, and Profitability dimensions to be positive over the long-term, which historical data has supported. The chart below shows the historical annualized premiums and returns in the U.S., developed ex-U.S., and emerging markets.
Over the past 10 calendar years, the Equity and Small Cap premiums have generally rewarded investors, but the Value and Profitability premiums have not. The Value premium in particular has been in the cross hairs of investors.
While these premiums have historically proven beneficial to investors, we also know that these premiums are volatile and can sometimes be negative from year-to-year. The chart below shows that by having a longer-term perspective, the probability of benefitting from the premiums is greatly increased. Please note, these premiums are also positive in the developed ex-U.S. and emerging markets. However, I am only showing the premiums over rolling time periods for the U.S. market because that is where we have the longest history of data.
We are confident the dimensions, which have provided enhanced returns in the past, will continue to work in the future. Yet, we recognize the long-term benefits are irrelevant if you can’t stick with it during periods of underperformance. This is why we structure portfolios to tilt towards these dimensions, rather than build portfolios investing purely along the dimensions. We are seeking to balance the long-term benefits of the dimensions with the short-term challenges of human behavior.
There may be the temptation to use the most recent past to predict the future and conclude that this approach to investing no longer works. However, the past suggests the premiums can materialize quickly. By remaining patient and disciplined, you will be better positioned to capture the potential outperformance associated with the premiums when they show up.