In the evolving landscape of financial investment, certain research papers have left an indelible mark, transforming investment theories and strategies. Notably, the 1952 introduction of Modern Portfolio Theory by Nobel Prize laureate Harry Markowitz was a game-changer. However, another groundbreaking study emerged in 1992 when Eugene Fama and Kenneth French from the University of Chicago proposed the existence of three investment factors that could predict asset returns. These factors—market, size, and value—were instrumental in shaping the way investors approach risk and return.
The Fama-French three-factor model had profound implications on asset pricing models. It suggested that riskier assets should yield higher returns, smaller companies generally have higher expected returns due to their inherent risk, and stocks with low prices relative to their book value typically outperform those with high prices. This model not only laid the groundwork for predicting excess equity returns but also indicated that by incorporating these factors into their investment strategies, investors could potentially outperform the market. For instance, U.S. small-cap value stocks have returned an annualized 13.6% from Jan. 1, 1972, to July 31, 2023, compared to the 10.5% return of the overall U.S. stock market.
Groundbreaking Investment Theories and Their Impact on Modern Investing
In the world of finance, certain research papers have significantly transformed the course of investment theories and practices. One such influential study emerged in 1992 when University of Chicago researchers Eugene Fama and Kenneth French proposed the existence of three investment factors that could predict asset returns. Their three-factor model revolutionized the investing world and laid the foundation for modern asset pricing models.
The Fama-French Three-Factor Model and Its Implications
The Fama-French model kicked off with the market factor, which represents the excess return of a broad market portfolio over a risk-free rate. It suggests that riskier assets should, on average, deliver higher returns than their less risk-prone counterparts. The model also introduced the size factor, indicating that small-cap stocks generally have higher expected returns due to their inherently higher risk. Finally, it incorporated the value factor, positing that stocks with low prices relative to their book value typically outperform those with high prices concerning their value.
The implications of the Fama-French model were profound. It highlighted the statistical significance of the size and value factors in predicting excess equity returns. This revelation meant that by integrating these factors into their investment strategies, investors could potentially reap returns surpassing those foreseen by just the market factor.
The Evolution of Investing and The Rise of ETFs
Nearly three decades later, the investing landscape has significantly morphed with the proliferation of financial technology. Exchange-traded funds (ETFs) have emerged as the preferred investment vehicles for many factor investors. Several ETF managers now provide investors with affordable and transparent avenues to delve into small-cap value investing. These ETFs present a variety of options for those eager to leverage the size and value factors.
A Closer Look at Some of the Best Small-Cap Value ETFs
Investors have a wide array of small-cap value ETFs to choose from. Some of the best ones to buy in 2023 include Vanguard Small-Cap Value ETF, SPDR S&P 600 Small Cap Value ETF, iShares Russell 2000 Value ETF, Avantis U.S. Small Cap Value ETF, Avantis International Small Cap Value ETF, Avantis All Equity Markets Value ETF, and Dimensional U.S. Small Cap Value ETF.
These ETFs offer different expense ratios and assets under management, providing investors with a range of choices depending on their financial goals and risk tolerance. For instance, the Vanguard Small-Cap Value ETF, with $26.3 billion assets under management and a 0.07% expense ratio, is a suitable option for investors looking for a low-cost, passively managed ETF for small-cap value exposure.
The Fama-French three-factor model has significantly impacted modern investing practices, leading to the rise of ETFs as popular investment vehicles. By integrating the size and value factors into their investment strategies, investors can potentially achieve higher returns. However, it’s crucial to remember that every investment comes with its own set of risks and rewards. Therefore, investors should carefully consider their financial goals, risk tolerance, and market conditions before investing in any financial product.