But even assuming that this concern is valid (I think LT bonds were paying around 6% in early 1970s??? and were up to the low teens by early 1980s), how do we know if/when it is going to happen or how it is going to unfold? During the 70s LT bonds severely underperformed for an entire decade because inflation was so bad. But the gold managed to do OK and eliminate the losses.

So we’ve had a period of bad LT bond performance and the portfolio did OK. The past does not predict the future, but we at least have one extended period of time where things worked out.

Then again, those 4% LT bond rates we have today could look pretty good if we get a Japan style slump where their LT bonds have languished in the 2% range for 20 years now.

Harry Browne talked about the bond questions in his radio shows where he used to get from people and how they could never buy them because they were so expensive only to watch them get more expensive.

In the end, you just can’t predict the future.

Over the last 10 years, a very good period for small-caps, TSM has outperformed the S&P500 by about 1%/year. Roughly equivalent to 80% S&P 500 / 20% small-cap.

Let me respond first by saying I’m not opposed to changes in the allocation that can improve performance. After all, I sometimes recommend people use ST treasuries for the cash allocation once they get beyond a year or so in living expenses covered in the Treasury MMF. But I do this knowing what the risks are. If someone is aware of the value tilting risks then I’m not going to tell them not to do it. I just think that there are some questions that need to be better answered and that keeping things simple has its own advantages.

Also I should add that many years in the investment markets have taught me to be extremely skeptical of all claims of a better mousetrap. If someone is offering returns that beat the market my red flags go up simply because history has shown that these methods do not hold up to scrutiny.

Now, to your points:

“1) All slices of stocks tend to be rather correlated so substituting one for another will still maintain the proper operation of the PP. Consider that Browne suggested actively managed small growth funds for a while and later suggested just a S&P500 index because it was simpler and less prone to manager error.”

This is true and not true. Yes, stocks tend to move together, but it is also true that some asset classes can move ahead or behind of others over stretches of time. After all, the principle of the value tilt argument is they tend to move higher than a broad based index fund. But this means they can also lag the index, too.

It is also true that the early portfolio Browne tried to pick funds that would add Beta to the stock allocation. When I asked his longtime partner, John Chandler, about why they stopped this advice he said that the problem is the markets tend to erase these advantages as the strategies of outperformance gain popularity. Eventually they found it just wasn’t worth the hassle.

“2) A TSM fund may technically contain small stocks but, they have no impact on performance.”

It is true that small stocks make up a relative tiny part of the index fund. The primary advantage the index has is in overall tax efficiency and costs as companies are not being constantly added and removed during index reformulations. The only reason a company typically leaves the index is when they go bankrupt. It is also, I believe, the most efficient way to capture market returns.

“3) Expenses are very important, but you selected a strawman for the small-value fund example. Conside VBR, a vanguard small-value ETF with 0.11% expense ratio and low turn-over. Or IWN with higher yield and 0.25% expense. ETFs are quite tax efficient as I am sure you know.”

This is not a Strawman because these funds were only recently made available at those fee price points. Before that you were paying much higher fees to access these sectors and some funds still charge those higher fees.

ETFs can be tax efficient but it depends on the index. The Russell 2000 for instance has very high turnover and is not tax efficient for small stocks. The S&P 600 (and value versions) with the iShares ETF (ticker: IJR and IJS) are better constructed and executed to reduce taxes. If I had to choose between the two for small value tilting I’d use the S&P 600 Value version.

Even then, these funds have only around five years of data for tax efficiency. It is quite likely their tax costs will continue to go up if we hit a sustained bull market in stocks.

“4) This conversation wouldn’t be worth having except for the little intsy wintsy fact that small-value stocks UTTERLY CRUSH the TSM over the long term. In fact they outperformed in 97% of the rolling 20 year periods since 1928 (see Figure 9-9 http://www.ifa.com/12steps/step9/step9page3.asp). $1 dollar invested in the TSM in 1928 would have turned into about $1,265 after 81 years but $1 dollar invested in small cap stocks would have turned into $17,230 ”

I’m skeptical of data from IFA. They created many of their indices for comparison from piecing together index funds results from unrelated funds. I posted about this at the Diehards forum, but point you to their webpages where they say, among other things:

http://www.ifa.com/btp/
http://www.ifa.com/library/support/data/IFAindexdata.asp

“”"Backtested performance also differs from actual performance because it is achieved through the retroactive application of model portfolios (in this case, IFA’s twenty index portfolios) designed with the benefit of hindsight. As a result, the models theoretically may be changed from time to time to obtain more favorable performance results. “”"

Also it was simply impossible to have invested a dollar back in 1928 in this asset class anyway. The people pushing these funds took a bunch of data and found what worked best in hindsight. Plus there could be survivorship bias involved and they are definitely using simulated data for parts because the records of small publicly traded companies are not as complete as the larger entities. Not only that, but there are no fees deducted from these findings and there is a conflict of interest in the research. IMO.

The conflict comes from the fact French and Fama both sit on the board of DFA who make their money by promoting funds that use their ideas. I’m not saying they are being untruthful, but I do think there MAY be an incentive to look for evidence that only supports their findings.

“5) As for the size and value premiums disappearing, I don’t have enough time/space to discuss the competing theories for why this may or may not take place. Just consider that it has not happened yet even though the secret has been out. For this too take place investors in aggregate would have to start getting as excited about $5mil cap concrete manufacturers as AAPL and CROX ”

Well I remember now that the broker bragging to me about using value index investing for their clients was Merrill Lynch. I suspect they aren’t the only ones letting their clients in on this secret. Also, there are myriad of cheap value index options available today that didn’t exist even 10 years ago. So it’s quite easy for anyone to adopt this strategy of value tilting.

I’m not so confident that any historical edge that did exist is going to remain. It’s far too easy and cheap today for any Joe on the street to value invest and I think this is definitely going to have an impact on the approach. We’ll just have to see I suppose.

Thanks for your comments. Heck, if it turns out in a few years that I’m wrong I’ll happily concede. I’m all for higher performance with the same or less risk. But my natural skepticism is preventing me from getting back onto the value tilting bandwagon (I was on it before).

But I don’t think you’re going to do that much potential damage to the portfolio if you decide to value tilt. Just be aware of the costs and the possibility that it may not work out as planned.

1) All slices of stocks tend to be rather correlated so substituting one for another will still maintain the proper operation of the PP. Consider that Browne suggested actively managed small growth funds for a while and later suggested just a S&P500 index because it was simpler and less prone to manager error.

2) A TSM fund may technically contain small stocks but, they have no impact on performance.

3) Expenses are very important, but you selected a strawman for the small-value fund example. Conside VBR, a vanguard small-value ETF with 0.11% expense ratio and low turn-over. Or IWN with higher yield and 0.25% expense. ETFs are quite tax efficient as I am sure you know.

4) This conversation wouldn’t be worth having except for the little intsy wintsy fact that small-value stocks UTTERLY CRUSH the TSM over the long term. In fact they outperformed in 97% of the rolling 20 year periods since 1928 (see Figure 9-9 http://www.ifa.com/12steps/step9/step9page3.asp). $1 dollar invested in the TSM in 1928 would have turned into about $1,265 after 81 years but $1 dollar invested in small cap stocks would have turned into $17,230 (http://www.ifa.com/images/12steps/step9/GrowthofDollarover81Year.jpg).

5) As for the size and value premiums disappearing, I don’t have enough time/space to discuss the competing theories for why this may or may not take place. Just consider that it has not happened yet even though the secret has been out. For this too take place investors in aggregate would have to start getting as excited about $5mil cap concrete manufacturers as AAPL and CROX

Thank for the great blog – keep it up!!