After the Enron debacle in 2002, Congress passed the Sarbanes-Oxley Act.  One obscure clause in the act required company insiders to report their insider trades electronically within a day. The reports would go into a Securities and Exchange Commission (SEC) database accessible to the public (if they knew how to query the database.)  Prior to that, company insiders had 15 days to report their insider trades in paper format. Those papers would then sit in an SEC library gathering dust. Periodically, a Wall Street Journal (WSJ) reporter would borrow the pile of papers and write a report on them.

As soon as the electronic reporting was implemented, I created a program to query the SEC database in real time. When a company insider sent in his trade, my program would pick it up instantaneously and send an alert to my cell phone.  In the next 30 seconds, I would call my broker and place a trade in the same direction as the insider. A few days later, when the insider trade finally got to the WSJ, the stock price got a pop and I would sell for a tidy profit. In six month’s time, I turned $300k into $2mm.  Using a spreadsheet, I calculated that at this rate I could be a billionaire within three years.

Then, I found this website. For a mere $20 monthly subscription, anybody could get the insider trade information in real time as well. I actually became a subscriber, just to check out how fast its information was. I found my program was one second faster than the website, but that wouldn’t be enough time for me to place a trade before the information became available to the website’s hundreds of subscribers and the market price began to react.

I called the proprietor of the website, trying to get him to shut it down, or at least delay the information. I let slipped that my program was one second faster.  The next day, he called me back to report good news: he went back to look at his code and managed to shave off the second.

This is the unstoppable march of the efficient market. I spent the next two years trying to find the next market inefficiency to exploit. In the process I gave back most of the $2mm I made.

I told this story to many of my wealth management clients to make sure they don’t fancy the latest hedge fund with a blown-out return.

Passive money holds the market portfolio. Active money jumps around, but on aggregate it also holds the market portfolio. Before investing costs, the two types of money must have the same returns; after investing costs, such as information acquisition, trading, taxes, etc., active money must earn less than passive money. It is arithmetic.

Though there are hundreds of mutual fund families in the United States, all but two are squarely in the passive camp: Vanguard and DFA.

Vanguard vs DFA

Vanguard pioneered index investing. DFA pioneered Fama/French factor-based asset-class investing. Vanguard and DFA have the following differences:

• Philosophically, Vanguard lives in the CAPM world: only market risk is compensated. DFA lives in the Fama/French three-factor world: in addition to market risk, small cap risk and value risk are also compensated. DFA’s core funds have a tilt towards value and small cap; Vanguard’s total market fund does not.
• Vanguard’s indexing approach limits it to the most liquid section of the market that has been indexed by commercial index companies. DFA’s approach allows investment in obscure corners of the equity markets, resulting in a more complete equity exposure.
• To track the commercial indexes closely, Vanguard ends up paying liquidity costs; by being passive, DFA extracts an illiquidity premium.
• Vanguard’s mutual funds are open to retail investors; they are subject to the vagaries of emotional fund flows. DFA’s funds are only available to institutions and select advisors; “hot money” that hurts returns is kept away.

Thus it appears that DFA is superior in all aspects. Not true! Vanguard is organized as a mutual company. DFA is a organized as a for-profit asset management company. There is less conflict of interest in Vanguard’s corporate structure – Vanguard fund managers do not need to serve two masters. They serve one, their funds’ shareholders.

Their portfolios are variations of the so-called 60/40 portfolio – about 60% in equity-like investments and 40% in bond-like ones.

Many other 60/40 portfolios have been decimated by this crisis. Even with recent gains, they are still far from recovering all their losses. How did I manage to pull even for my clients? There are a few key lessons I’d like to share.

Prescience is not required

There are financial advisors who claim they saw the crisis coming and moved their clients’ money into cash before sh*t hit the fan. I am not one of them. Though I did see storm clouds gathering, I underestimated the severity and stuck with their original investment plans through the crisis.

Keep the bond section pure

One of the biggest reason that many 60/40 portfolios took a big hit was that the bond portions were filled with higher yielding corporate bonds, even junk bonds.

Fama and French, in their research paper “Common Risk Factors in the Returns of Stocks and Bonds,” documented that term risk and credit (default) risk are not sufficiently compensated by the market. In laymen’s term, those risks are not worth taking.

Many financial advisors, however, like to put investors’ money in higher yielding bonds since the additional 1% in yield  is great for marketing, Little did investors realize that for that additional 1% in yield during good times, they would suffer 40% in losses during bad ones.

I put my clients’ bond portion mostly in short-term Treasuries; during the depth of the crisis when all other types of bonds fell by 30% to 40%, they rallied by 8% to 10%.

Rebalance religiously

At the beginning of 2009, I was able to reallocate the stronger bond portion to the much weaker equity portion just in time to catch the equity rally that followed. It is easy to recount now, but at the time when the market was permeated with fear, it took a written plan and steely commitment to it to excecute the rebalancing.

If you want to make sure that the bond portion of your portfolio is strong enough to provide protection during bad times, order my Portfolio Review service.

Fischer Black, the co-inventor of the Black-Scholes option pricing formula, suggested that the Fama and French results might be specific to the period (from 1963 to 1990) examined. In his opinion, the Value Premium is unlikely to repeat in the future.

The debate has important ramifications for investors who want to use the Value Premium to improve their investment returns. To find out if Black is right, I examined both the pre-1963 and post-1990 U.S. stock market data for evidence of the Value Premium.

I used the data available in French’s data library. Specifically, I compared two portfolios:

* Lo 30: Stocks with the lowest 30% book-to-market ratio (growth portfolio)
* Hi 30: Stocks with the highest 30% book-to-market ratio (value portfolio)

The results are presented in the following table:

Table: Average returns of growth and value portfolios

It is clear that the value premium was present before 1963. After 1990, it continued to be present in the market, though at a reduced magnitude.

Fama and French did a study of international stock markets to find evidence of the Value Premium. The following results are taken their paper “Value vs Growth: The International Evidence.”

Table: Average returns of international growth and value portfolios based on MSCI data of 12 EAFE countries

The evidence convinces me that the Value Premium is prevalent and persistent. Are you convinced? Please share your thoughts with me.

Warning: you may not be able to take advantage of the Value Premium simply by buying any “value” mutual funds since most mutual funds (with the exception of DFA funds) use Morningstar’s definition of “value” that is quite different from Fama and French’s.