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Should You Rethink How You Diversify?
Plus July Market Report

John Gorlow | Aug 17, 2018

Occasionally a cornerstone of one’s investment strategy is called into question. Recently, some pundits have claimed that adequate diversification is no longer possible due to a diminishing number of publicly traded US stocks. Join us for a closer look at this issue—and the hype and fear that surround it—following our July market review.

July Market Report 
Global Markets
Global Markets as measured by the MSCI All Country World Index posted a broad 3.02% return for July, bringing its YTD return to 2.57% and its trailing one-year return to 10.97%. Total cumulative returns on the All Country World Index for the trailing two years slid slightly to 29.89% from 31.53% in June.
US Equities
The S&P 500 posted a 3.72% total return in July, its fourth consecutive month of positive returns, bringing its YTD return to 6.47% and its one-year return to 16.24%. The S&P Small Cap 600 index rose for the fifth consecutive month adding 3.16%, bringing its YTD return to 12.84% and its one-year return to 23.11%. From a style perspective, growth continued to dominate across the entire spectrum of market caps. 
International Equities
The MSCI World Ex US Index posted a  2.46% return in July, reversing its downward trend over the past two months, bringing its YTD return to almost break-even, and its trailing one-year return to 6.5%. International Small Cap stocks, as defined by the MSCI World Ex US Small Cap Index, lagged its Large Cap counterpart for July and YTD,  returning 0.57% and negative 0.88% respectively. But for the trailing one-year
the International Small Cap Index outperformed its big brother, returning 8.68%. 
Emerging Market Equities
Emerging markets broke into the black in July, posting a 2.20% return following declines of negative -4.15% in June and negative -3.54% in May. YTD the broad emerging market index remains in the red, off negative -4.61% with dividends included. The one-year return remained positive but continued to slide, up 4.36% in July compared with 8.20% in June. Over the trailing two-year period, returns for emerging markets with dividends totaled 30.28%. 
Real Estate Securities
As measured by the Dow Jones US Select Reit Index, US Real Estate securities continued their winning ways for the fifth consecutive month, returning 0.55% in July. International Real Estate securities as measured by the S&P Global Ex-US Reit Index added 1.23% for July.
Fixed Income Securities
The 10-year US Treasury Bond closed the month at 2.96%, up from last month’s 2.86%. Barclay’s US Corporate Bond High Yield Index added 1.09%. Barclay’s US Aggregate Bond Index was flat. Barclay’s US TIP Index was down -0.48%. The US Three-Month T Bill gained 0.48%. Oil decreased to close at $68.43 per barrel. Gold tumbled for the month, closing at $1,232.90 and setting a new low for 2018.
Feature Article
Premium Expectations in A Shrinking Universe
Everything changes over time, including the composition of the stock market. Still, you may be surprised to learn that between the mid-1990s and 2016, the number of publicly traded companies on US stock exchanges declined from approximately 8,000 to 3,700 companies. That’s more than a 50% decrease in US public-company investment opportunities. 
This decline should concern investors, suggests a 2016 report by Professor Rene Stultz for the National Bureau of Economic Research (NEBR). A recent New York Times article by Jeff Sommer sums up the NEBR analysis: it means fewer opportunities for investors, less transparency, and ultimately less innovation in the American economy (The Stock Market is Shrinking. That’s a Problem for Everyone. 4-August 2018). The report suggests that most investors may not be aware of what they’re missing as the number and variety of US public corporations has declined. 
Of particular concern is how a shrinking universe of US stocks might affect the size premium, that is, the higher return that can be expected over time by investing in small- versus large-cap stocks. Small-cap stocks are at the heart of the American success story. Remember when Apple was a startup (and rival to another startup named Microsoft)? Hewlett Packard was launched out of a garage, and Starbucks was a one-off coffee shop that investors turned into an international success story. Each of these companies was once a little guy flying beneath the radar. 
For a variety of reasons, there are likely to be fewer of these stories in America’s future. Today startups are more likely to be building intellectual property (IP) than widgets. They closely guard their IP, stay private for longer, and are more likely to be sold to bigger companies than go through the public disclosures of an IPO. This could be a long-term or short-term trend. The question is, should it change your expectations or behavior as an investor?
No, concludes a May 2018 study from DFA. Yes, say private equity firms and large endowments who frequently invest in small, privately held companies. Let’s look at the research and track records. 
First, a quick reminder of the types of premiums investors can expect—proven by a century’s worth of well-vetted research and stock market evidence. Three factors can help identify securities with higher expected returns:

• The size premium (small vs. large): smaller companies outperform larger companies. 
• The value premium (higher vs. lower stock price): value companies outperform growth companies. 
• The profitability premium: more profitable companies outperform less profitable companies. 
These three factors can’t be counted on to churn out higher returns like clockwork, just as a well-diversified portfolio can’t be expected to produce a positive return year after year. Many circumstances (nearly always unanticipated and sudden) can affect equity performance. And yet we use these historically reliable factors to identify securities that we believe are more likely over time to deliver higher rates of return. The benefit: investors can “tilt” toward small cap and value stocks within the equity portion of their portfolios and increase expected return without raising their overall stock-bond ratio. 
As US stock choices decrease, we want to know if the size premium can still be trusted. If there’s a change in the overall composition of the market, does it make sense to invest the same way and expect the same premiums as in the past?  
Small Caps Under the Microscope 
When DFA examined the size premium across all markets over a 42-year span (January 1975 to December 2017), it was striking to see that even as US stocks were contracting by half, the universe of publicly traded stocks outside the US climbed steeply to more than 39,000 in total. Many factors may have contributed to the decline and spike, which we won’t get into here. But we do want to look at performance objectively.
DFA examined the size premium in developed markets, and found no relationship between the number of stocks and the expected premium. In other words, a smaller market should not cause investors to expect the premium to shrink. Of 22 developed markets examined, Ireland was the smallest of all, with just 55 stocks, and yet had the highest average monthly size premium at 0.47%. 
DFA further refined the size universe by looking at what might have happened if a hypothetical US market had been limited only to the largest 3,400 stocks. Annualized compound return for the top 3,400 stocks was 12.58%, 12.31% for large caps, and 14.53% for small caps—again, the expected size premium showed up. 
Results were even better (15.76%) for small caps ex small cap growth and low profitability stocks, exactly as research suggests should be the case. The annualized small cap premium was 2.22% over the 1975 - 2017 timeframe, or 3.44% for small caps ex small growth and low profitability. 
Importantly, DFA showed that even as the number of securities shrank over time, the proportion of small caps to large caps remained consistent. The biggest 20% of names accounted for 92.2% of the market in 1997, and 89.9% in 2017. The smallest 20% of names accounted for 0.2% of the market in 1997, and 0.1% in 2017. 
What’s this prove? You can trust the size premium. “We observe a positive size premium in big markets, in small markets, in markets which naturally vary in size through time, and in a hypothetical market that does not vary in size at all,” DFA concluded, adding that “There is not compelling indication that a smaller number of publicly listed stocks is correlated with a smaller size premium.” The results for emerging markets, omitted for brevity, come to the same conclusion.
And yet…perhaps you’re sorely tempted to add private, fast-growing small cap exposure to your portfolio.
Private equity firms will tell you that’s an excellent idea. With their deep pockets and inside information on small, non-public companies, they may have good hunches about who the next Google or Apple might be. (Or maybe not.) Endowment funds share similar strategies: find the next hot thing and invest, then rake in the money. 
Buyer beware. Results are hard to verify. Strategies are vague. Valuations are subjective. The cost of turnover in these funds isn’t easily observable. Fees are excessive, and risk is high. These concerns aside, let’s look at the data. 
Some 275 college and university endowments included in a 2016 Commonfund study collectively had an average of 53% exposure to alternatives, of which 21% was in private equity and 11% in private equity real estate. The rest of the alternatives were in hedge funds, venture capital, real estate assets, commodities, and distressed debt. In other words, these portfolios had approximately 17% in private equity and private equity real estate (53% x 32%=17%). Yet with all the highly paid expertise, effort, and over-weights to alternatives, these endowments were not able to beat a Dimensional 60/40 index portfolio net of fees over the 10- year period ending June 2016. And that’s before the considerable internal costs of managing these investments, which would make the Commonfund performance even worse. (Both Vanguard and DFA reached similar conclusions with slightly different methodologies.) Bottom line, not only did most participants fail to make the returns they expected, they significantly underperformed their composite benchmarks.
Hold on. If the premiums that the market returns over time haven’t changed, why would you even consider adding additional types of assets or strategies to your portfolio for diversification beyond stocks, bonds, and cash unless they increase expected return or reduce expected volatility in a cost efficient and reliable way? There’s no need to experiment with unknown risk, added complexity, lack of transparency and high costs. The research shows that you can continue to diversify very effectively, even in a shrinking universe of stocks. 
At Cardiff Park, our job is to maximize your returns for the amount of risk you’re willing and able to take. We strive to keep you well diversified and to support your investment goals even as the world around you changes rapidly. Trust data, not promises, and count on the inherent rewards of sticking to a proven strategy and long-term plan. Even the smallest stocks in your portfolio will reward you for that. 
Do you have questions or concerns? Call me, I am here to help. 
John Gorlow
Cardiff Park Advisors
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