Voices: When evidence is solid and returns aren’t
This March is the 10-year anniversary of the U.S. stock market’s turnaround from the depths of the 2008 financial crisis. A lot has changed since March 2009. Investors are more fee conscious, more willing to venture into foreign markets and open to a broader variety of investing styles such as value, momentum and quality.
That evolution was no accident. It was the work of a movement known as evidence-based investing, of which I’m an adherent. The basic premise is that investors should rigorously test the validity of an investment idea — or rely on credible research that has done so — before putting their money behind it.
The problem is that evidence-based investing has been a bust over the last decade. Everything investors had been doing wrong, according to the evidence, turned out to be right. While I think the last 10 years are going to turn out to be an anomaly, I wouldn’t be surprised if evidence-based portfolios become a tougher sell for the average investor.
Before the recent broadening, the typical U.S. stock portfolio consisted mainly of a mishmash of U.S. growth stocks or actively managed growth mutual funds. If you had looked at the evidence a decade ago, you would have most likely concluded that investors’ fondness for U.S. growth stocks was misplaced.
For one, there was no reason to expect that U.S. stocks would necessarily fare better than foreign ones over reasonably long periods. The S&P 500 Index had beaten the MSCI EAFE Index, a collection of stocks from developed countries outside the U.S., 47% of the time over rolling five-year periods from December 1974 to 2008, including dividends, the longest period for which monthly returns are available. Similarly, the S&P 500 beat the MSCI Emerging Markets Index 41% of the time over rolling five-year periods from December 1992 to 2008.
In addition, while growth companies may be promising businesses, the data showed that their stocks were poor performers. Value stocks, as defined by the cheapest 30% of U.S. stocks by price-to-book ratio and weighted by market value, beat growth, the most expensive 30%, by four percentage points a year from July 1926 to 2008, according to numbers compiled by Dartmouth professor Ken French.
Value also beat growth 90% of the time over rolling 10-year periods. And it’s not just value. Other styles of investing routinely beat growth, too, such as momentum, quality and low volatility.
The implication was clear: Invest globally and across more styles.
That’s easier said than done. Investors’ home bias is legendary and endorsed by investing gurus Warren Buffett and Vanguard Group founder John Bogle, each of whom largely dismissed foreign stocks.
Investors were just as fond of growth stocks. There was $189 billion invested in U.S. large-cap growth mutual funds at the end of 1993, compared with $135 billion in large-cap blend and $95 billion in value, according to Morningstar. Even after the dot-com bust in 2000, which disproportionately battered growth stocks, and value’s subsequent rout of growth through 2007, there was $614 billion invested in growth mutual funds and ETFs at the end of 2008, compared with $408 billion in value funds.
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Nonetheless, investors must have found the evidence compelling because they plowed more money into foreign stock funds than U.S. ones over the last decade, and less into growth funds than other styles. Unfortunately, their timing couldn’t have been worse. U.S. growth stocks have been among the best performers over the last decade.
The Russell 1000 Growth Index beat the Russell 1000 Value Index by 2.8 percentage points a year through February. And the growth index bested global stocks by an even wider margin, outpacing the MSCI All Country World Index by 4.9 percentage points a year.
Investors pulled a net $453 billion from U.S. large-cap growth mutual funds from 2009 to 2018, but stock pickers are having the last laugh. I counted 1,084 actively managed funds, including their various share classes, with an average expense ratio of 1.1% a year.
That fee drag prevented most managers from keeping pace with the growth index, but they beat the all-world index by an average of 3.4 percentage points a year net of their hefty fees over the last decade through February. Only 34, or just 3.1%, underperformed the all-world index.
The conundrum is that the results of a few years shouldn’t override decades of evidence, and nothing precludes U.S. growth stocks from enjoying a star turn occasionally. But if they continue to dominate markets, it won’t be easy for investors to persuade themselves to hang on to their new evidence-based portfolios.