All Day, Every Day, Multifactor All the Way
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The size, value, and profitability premiums complement one another.
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Dimensional pursues all three premiums in both core and component strategies. Our value strategies, for instance, are also exposed to the size and profitability premiums.
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Live performance shows that premium integration—especially the implementation of profitability in 2014—has served investors well.
All Dimensional equity strategies—core or component—are multifactor solutions. They integrate the size, value, and profitability premiums systematically. In this note, we review the evidence behind this approach. We also demonstrate the added value for investors using the live performance of Dimensional strategies. Lastly, we discuss how our daily process allows us to account for additional return drivers like asset growth and momentum.
Better Together
Value stocks tend to be smaller and less profitable than growth stocks. Conversely, more profitable stocks tend to command higher valuations. These interactions mean the size, value, and profitability premiums can deliver better outcomes for investors when considered together.
Exhibit 1 illustrates this idea. Using developed-markets data since 1990, we show average monthly stock returns grouped by market cap, price-to-book, and operating profitability. The left table is for large caps, while the right one is for small caps.
Interacting Premiums
Past performance is no guarantee of future results.
Three observations stand out. First, the premiums are positive. The size premium is seen by comparing the two tables. All cells among small caps outperform their equivalents among large caps, except for low-profitability growth (the top left cell in each table). The value and profitability premiums are in all cases positive, as seen by the column and row spreads (in blue).
Second, value and profitability work well together. In each table, the return difference between high-profitability value and low-profitability growth (the spread along the diagonal, in green) is positive and at least as large as the individual value and profitability premiums.
Third, taking size into account can magnify the value and profitability premiums. The individual premiums among small caps exceed their counterparts among large caps (the spreads in blue) and the same is true for the return difference between high-profitability value and low-profitability growth (the spreads in green).
Multifactor Everywhere
These results suggest that the premiums can complement one another when integrated into a strategy. Integration is the crux of Dimensional’s core strategies. But our component strategies are also multifactor solutions. Take, for instance, our value strategies. They emphasize smaller and more profitable value stocks. This increases their expected returns while mitigating the impact of potential “value traps” (stocks with low valuations due to low expected cash flows, not high discount rates).
Exhibit 1 showed compelling evidence for integrating the premiums. Still, going from research to live strategies entails many trade-offs. A few examples make this clear. First, excluding low-profitability growth stocks from the small-cap universe is an effective way to increase expected returns. Yet, a too aggressive screen can result in a poorly diversified portfolio. Second, emphasizing more profitable stocks has many benefits in a value strategy. Their relatively high valuations, though, can wash out the value exposure if the profitability tilt is too strong. Third, some turnover is unavoidable when excluding or re-weighting stocks. But excessive turnover, especially among less liquid stocks, can lead to high trading costs that outweigh the benefits. Striking the right balance requires expertise in designing and managing strategies.
Moreover, there is no “one size fits all” when it comes to implementation. Each of our strategies pursues the size, value, and profitability premiums in a way tailored to its investable universe. In large caps, we target the premiums through both exclusions as well as over- and underweights. In small caps, where deviations from market-cap weights would be more costly to implement, we apply only exclusions. In each case, the degree of exclusion or re-weighting balances expected benefits and costs. Exhibit 2 summarizes the design of four Dimensional equity strategies within developed markets.
Multiple Flavors, All Multifactor
Live Results
There is a simple test of whether a strategy has benefitted from integrating premiums. Did it outperform when the premiums were positive? In Exhibit 3, we show that the answer is “yes” for the Dimensional strategies mentioned above. We plot their average excess returns over comparative indices during months when the premiums materialized. To proxy for the individual premiums and their interactions, we use the sorts from Exhibit 1.1 The start date, 2014, coincides with Dimensional’s implementation of the profitability premium across these strategies.
Value-Add from Premium Integration
Average monthly excess returns vs. comparative indices (in % per month) during months with positive premiums
Past performance is no guarantee of future results. Performance may increase or decrease as a result of currency fluctuations.
All four strategies, core or component, outperformed their comparative indices when the size, value, and profitability premiums were positive. Moreover, they all outperformed when high-profitability value stocks outperformed low-profitability growth stocks—that is, when the interaction between the value and profitability premiums was positive.2
The results for the two value strategies deserve special attention. First, they highlight that the strategies captured more than the value premium. Indeed, they also outperformed when the size and profitability premiums were positive. The latter is no small feat since a lower valuation tends to come with lower profitability. Second, the results demonstrate some of the advantages over an index approach. Take, for instance, the ability to capture the profitability premium. Our value strategies use price-to-book to identify value stocks and then emphasize profitable stocks within that space using operating profitability (see Exhibit 2). The indices, however, identify the value space using multiple measures of relative price, some of which blend pure valuation with pure profitability.3 Our strategies’ use of separate measures allows for a more precise exposure to the premiums. The indices’ exposure to profitability is often at the expense of a more focused exposure to value. In the end, our strategies outperformed the indices not only when the profitability premium was positive, but also when the interaction between the value and profitability premiums was positive.
Implementing the Great Ideas in Finance
The integration of multiple premiums across all our strategies highlights a broader point. Working with Dimensional means signing up for the great ideas in finance that can work within each asset class. If a new idea makes sense, passes our robustness tests, and can add value in the real world, it may make it into our strategies. Few ideas pass this high bar. But, when they do, they tend to deliver good outcomes for our clients.
Dimensional’s decision to incorporate profitability across its existing strategies in 2014 is testament to this approach. Since then, the profitability premium has been 6.2% and 3.1% annualized in developed and emerging markets.4 Moreover, low-profitability small-cap growth stocks underperformed the collective small-cap universe by 2.6% and 3.8% annualized in the two markets.5 The outperformance against comparative indices shown in Exhibit 3 demonstrates that our strategies benefited from the integration of profitability.
Being multifactor, however, does not stop with size, value, and profitability. Since 2019, our equity strategies also integrate the investment premium by excluding small caps with high asset growth. These companies also tend to underperform the collective small-cap universe. Since implementation, they have continued to do so by 10.7% annualized in both developed and emerging markets.6 Price momentum is another example. Because we rebalance our strategies daily, we can screen our buys and sells for such short-lived signals about expected returns in a way that avoids unnecessary turnover and costs. These and other aspects of our implementation add incremental value for our clients. We do this all day, every day. And our research into strategy and process enhancements remains ongoing.
Appendix: 2x2x2 Premium Definitions
The premiums used in Exhibit 2 are based on the 2x2x2 sorts for developed markets from Exhibit 1.
The size premium is defined as the average small-minus-large return difference across the price-to-book and profitability cells in Exhibit 1, excluding the cells of small low-profitability growth stocks (we typically underweight or exclude these stocks in our strategies due to their low expected returns). The value premium is defined as the average value premium across the size and profitability segments. The profitability premium is defined as the average profitability premium across the size and price-to-book segments. We construct the premiums this way to better isolate their individual effects.
Appendix: Index Definitions
Fama/French High Profitability Index and the Fama/French Low Profitability Index for developed markets: Courtesy of Fama/French from Bloomberg securities data. Includes stocks in the upper and lower 30% operating profitability range in each region; companies weighted by float-adjusted market cap; rebalanced annually in June. Operating profitability for June of year t is annual revenues minus cost of goods sold, interest expense, and selling, general, and administrative expenses divided by book equity for the last fiscal year end in t-1. Fama/French and multifactor data provided by Fama/French.
Fama/French High Profitability Index and the Fama/French Low Profitability Index for emerging markets: Courtesy of Fama/French from Bloomberg and IFC securities data. Includes stocks in the upper and lower 30% operating profitability range in each country; companies weighted by float-adjusted market cap; rebalanced annually in June. Operating profitability for June of year t is annual revenues minus cost of goods sold, interest expense, and selling, general, and administrative expenses divided by book equity for the last fiscal year end in t-1. Fama/French and multifactor data provided by Fama/French.
Dimensional Global Unadjusted Small Index: January 1990 - Present: Market-capitalization-weighted index of small company securities in the eligible markets. The index monthly returns are computed as the simple average of the monthly returns of four sub-indices, each one reconstituted once a year at the end of each quarter of the year. Maximum index weight of any one company is capped at 5.0%. Countries currently included are Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Hong Kong, Ireland, Italy, Japan, Netherlands, New Zealand, Norway, Singapore, Spain, Sweden, Switzerland, United Kingdom, and United States. Exclusions: REITs and Investment Companies. Source: Bloomberg. The Dimensional Global Unadjusted Small Index has been retrospectively calculated by Dimensional Fund Advisors and did not exist prior to April 2019. Accordingly, the results shown during the periods prior to April 2019 do not represent actual returns of the Index. Backtested index performance is hypothetical and is provided for informational purposes only to indicate historical performance had the index been calculated over the relevant time periods. Backtested performance results assume the reinvestment of dividends and capital gains. The Index is unmanaged and is not subject to fees and expenses typically associated with managed accounts or investment funds. Investments cannot be made directly in an index. Past performance is no guarantee of future results. Dimensional Index data compiled by Dimensional.
Dimensional Global Small Cap Growth Low Profitability Index: January 1990 - Present: Consists of small cap securities in the eligible markets with the lowest profitability and highest relative price within their country’s small cap universe, after the exclusion of utilities and companies with either negative or missing relative price data. Profitability is defined as operating income before depreciation and amortization minus interest expense divided by book equity. The index monthly returns are computed as the simple average of the monthly returns of four sub-indices, each one reconstituted once a year at the end of each quarter of the year. Countries currently included are Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Hong Kong, Ireland, Italy, Japan, Netherlands, New Zealand, Norway, Singapore, Spain, Sweden, Switzerland, United Kingdom, and United States. Exclusions: REITs and Investment Companies Source: Bloomberg. The Dimensional Global Small Growth Low Profitability Index has been retrospectively calculated by Dimensional Fund Advisors and did not exist prior to October 2018. Accordingly, the results shown during the periods prior to October 2018 do not represent actual returns of the Index. Backtested index performance is hypothetical and is provided for informational purposes only to indicate historical performance had the index been calculated over the relevant time periods. Backtested performance results assume the reinvestment of dividends and capital gains. The Index is unmanaged and is not subject to fees and expenses typically associated with managed accounts or investment funds. Investments cannot be made directly in an index. Past performance is no guarantee of future results. Dimensional Index data compiled by Dimensional.
Dimensional Global Small High Asset Growth Index: January 1990 - Present: Consists of small cap securities in the eligible markets with the highest asset growth within their country’s small cap universe. Asset growth is defined as change in total assets from the prior fiscal year to current fiscal year. The index monthly returns are computed as the simple average of the monthly returns of four sub-indices, each one reconstituted once a year at the end of each quarter of the year. Countries currently included are Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Hong Kong, Ireland, Italy, Japan, Netherlands, New Zealand, Norway, Singapore, Spain, Sweden, Switzerland, United Kingdom, and United States. Exclusions: REITs and Investment Companies Source: Bloomberg. The Dimensional Global Small High Asset Growth Index has been retrospectively calculated by Dimensional Fund Advisors and did not exist prior to November 2019. Accordingly, the results shown during the periods prior to November 2019 do not represent actual returns of the Index. Backtested index performance is hypothetical and is provided for informational purposes only to indicate historical performance had the index been calculated over the relevant time periods. Backtested performance results assume the reinvestment of dividends and capital gains. The Index is unmanaged and is not subject to fees and expenses typically associated with managed accounts or investment funds. Investments cannot be made directly in an index. Past performance is no guarantee of future results. Dimensional Index data compiled by Dimensional.
Dimensional Emerging Markets Unadjusted Small Index: January 1994 - Present: Market-capitalization-weighted index of small company securities in the eligible markets. The index monthly returns are computed as the simple average of the monthly returns of four sub-indices, each one reconstituted once a year at the end of each quarter of the year. Maximum index weight of any one company is capped at 5.0%. Countries currently included are Brazil, Chile, China, Colombia, Czech Republic, Hungary, India, Indonesia, Malaysia, Mexico, Peru, Philippines, Poland, South Africa, South Korea, Taiwan, Thailand, and Turkey. Exclusions: REITs and Investment Companies. Source: Bloomberg. The Dimensional Emerging Markets Unadjusted Small Index has been retrospectively calculated by Dimensional Fund Advisors and did not exist prior to April 2019. Accordingly, the results shown during the periods prior to April 2019 do not represent actual returns of the Index. Backtested index performance is hypothetical and is provided for informational purposes only to indicate historical performance had the index been calculated over the relevant time periods. Backtested performance results assume the reinvestment of dividends and capital gains. The Index is unmanaged and is not subject to fees and expenses typically associated with managed accounts or investment funds. Investments cannot be made directly in an index. Past performance is no guarantee of future results. Dimensional Index data compiled by Dimensional.
Dimensional Emerging Markets Small Cap Growth Low Profitability Index: January 1994 - Present: Consists of small cap securities in the eligible markets with the lowest profitability and highest relative price within their country’s small cap universe, after the exclusion of utilities and companies with either negative or missing relative price data. Profitability is defined as operating income before depreciation and amortization minus interest expense divided by book equity. The index monthly returns are computed as the simple average of the monthly returns of four sub-indices, each one reconstituted once a year at the end of each quarter of the year. Countries currently included are Brazil, Chile, China, Colombia, Czech Republic, Hungary, India, Indonesia, Malaysia, Mexico, Peru, Philippines, Poland, South Africa, South Korea, Taiwan, Thailand, and Turkey. Exclusions: REITs and Investment Companies. Source: Bloomberg. The Dimensional Emerging Markets Small Growth Low Profitability Index has been retrospectively calculated by Dimensional Fund Advisors and did not exist prior to April 2019. Accordingly, the results shown during the periods prior to April 2019 do not represent actual returns of the Index. Backtested index performance is hypothetical and is provided for informational purposes only to indicate historical performance had the index been calculated over the relevant time periods. Backtested performance results assume the reinvestment of dividends and capital gains. The Index is unmanaged and is not subject to fees and expenses typically associated with managed accounts or investment funds. Investments cannot be made directly in an index. Past performance is no guarantee of future results. Dimensional Index data compiled by Dimensional.
Dimensional Emerging Markets Small High Asset Growth Index: January 1990 - Present: Consists of small cap securities in the eligible markets with the highest asset growth within their country’s small cap universe. Asset growth is defined as change in total assets from the prior fiscal year to current fiscal year. The index monthly returns are computed as the simple average of the monthly returns of four sub-indices, each one reconstituted once a year at the end of each quarter of the year. Countries currently included are Argentina, Brazil, Chile, China, Colombia, Czech Republic, Hungary, India, Indonesia, Malaysia, Mexico, Peru, Philippines, Poland, South Africa, South Korea, Taiwan, Thailand, and Turkey. Exclusions: REITs and Investment Companies. Source: Bloomberg. The Dimensional Emerging Markets Small High Asset Growth Index has been retrospectively calculated by Dimensional Fund Advisors and did not exist prior to November 2019. Accordingly, the results shown during the periods prior to November 2019 do not represent actual returns of the Index. Backtested index performance is hypothetical and is provided for informational purposes only to indicate historical performance had the index been calculated over the relevant time periods. Backtested performance results assume the reinvestment of dividends and capital gains. The Index is unmanaged and is not subject to fees and expenses typically associated with managed accounts or investment funds. Investments cannot be made directly in an index. Past performance is no guarantee of future results. Dimensional Index data compiled by Dimensional.
Five-Year Performance
Past performance is no guarantee of future results. Performance may increase or decrease as a result of currency fluctuations. There is no guarantee strategies will be successful.
Footnotes
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1For simplicity, we use market-wide versions of the size, value, and profitability premiums for all the strategies. For the interaction between the value and profitability premiums (i.e., “high-profitability value minus low-profitability growth”), we use a definition that in each case corresponds more closely to the strategy’s investable universe. The results in Exhibit 3 are robust to using premiums that in each case correspond more closely to the strategy’s investable universe. They are also robust to using a market-wide version of the interaction between the value and profitability premiums for all the strategies.
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2The variation in the magnitude of outperformance across the strategies reflects the differences in their design, the different comparative indices, and the volatility of the premiums.
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3The MSCI World Value Index and MSCI World SMID Value Index select securities based on three measures: book-to-price, dividend-to-price, and 12-month forward earnings-to-price. Measures such as earnings-to-price conflate valuation and profitability. High earnings-to-price can be due to high earnings-to-book (a profitability measure), high book-to-price (a valuation measure), or a combination. A company can appear as “value” based on earnings-to-price despite a high valuation so long as it is sufficiently profitable. We believe using single, separate measures for valuation and profitability is a better approach that allows more control over premium exposures.
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4These figures are based on the differences in annualized compound returns between the Fama/French High Profitability Index and the Fama/French Low Profitability Index for developed and emerging markets. The period is January 2014 through June 2022. See “Appendix: Index Definitions.”
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5For developed markets, the figures are based on the differences in annualized compound returns between the Dimensional Global Unadjusted Small Index and the Dimensional Global Small Cap Growth Low Profitability Index. For emerging markets, the figures are based on the differences in annualized compound returns between the Dimensional Emerging Markets Unadjusted Small Index and the Dimensional Emerging Markets Small Cap Growth Low Profitability Index. The period is January 2014 through June 2022. See “Appendix: Index Definitions.”
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6For developed markets, the figures are based on the differences in annualized compound returns between the Dimensional Global Unadjusted Small Index and the Dimensional Global Small High Asset Growth Index. For emerging markets, the figures are based on the differences in annualized compound returns between the Dimensional Emerging Markets Unadjusted Small Index and the Dimensional Emerging Markets Small High Asset Growth Index. The period is January 2019 through June 2022. See “Appendix: Index Definitions.”
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