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The first edition of Larry Swedroe’s and Kevin Grogan’s book, Reducing the Risk of Black Swans, was an instant classic. For the first time, the authors introduced to retail investors the idea that they don’t need to rely so heavily on equity beta to generate the long-term returns they require to meet their investment goals. Instead, they proposed that investors should seek to harvest returns from other risk factors – specifically the small-cap and value premia – to seek equity-like returns with less exposure to equity bear markets.
Reducing the Risk of Black Swans: Using the Science of Investing to Capture Returns with Less Volatility by Larry Swedroe, Kevin Grogan
In this second edition, Larry and Kevin take the concept much further. Taking advantage of the democratization of more esoteric alternative return premia over the past five years, they build a compelling case for a genuine multi-factor strategy that is accessible to retail investors. They make a rigorously defended case for allocations to a variety of academically validated strategies with successful live track records and associated funds, which are uncorrelated with one another, and traditional portfolio constituents. The resulting portfolio has the potential to deliver equity-like returns over the long term, with surprisingly little dependence on the equity risk premium (ERP).
The book begins with a review of the long-term evidence on the ERP. This is an intuitive place to start, as equities dominate most investors’ portfolios. Larry and Kevin document a strong relationship between valuations and long-term returns to stocks. While there is a wide distribution of potential outcomes, average returns are much lower when stocks are expensive in the context of their historical range of valuations. The authors’ models show future returns for stocks are likely to be well below their long-term average. This sets the stage for an exploration of alternative sources of return to help fill the gap.
The first edition spent a great deal of time exploring the history of factor investing. This edition preserves the original’s in-depth background on the arc of factor investing in academia. There is an exploration of the most common factor models, with a focus on CAPM as well as Fama-French and AQR factors. The authors take time to show that these factors represent alternative sources of return, and that they are uncorrelated to the ERP. As a result, investors can create more efficient portfolios – that is, portfolios with higher expected returns at the same level of risk, or similar returns with less risk – by incorporating exposures to these factors.
A case study
The authors provide a case study that is especially salient for risk-averse investors. Consider a world with just two investments – the U.S. total-market equity index with an expected return of 7% and five-year Treasury bonds at 5%. An investor with a required nominal return of 6.5% would to allocate 75% to equities (0.75 * 7%) + (0.25 * 5%) = 6.5%. Now let’s expand our investment universe to include exposures to two well-known factors: small cap and value. Per the authors, small-value stocks have historically produced a premium return of 3.8% per year over the U.S. total market. By allocating half of the equity sleeve of the portfolio to the U.S. total market and the other half to U.S. small-value stocks, an investor would have achieved his target 6.5% return with just a 40% allocation to stocks, and 60% allocation to bonds: (0.2 * 10.8%) + (0.2 * 7%) + (.6 * 5%) = 6.56%.
It is this revelation that invokes the title of the book. Recall that Nassim Taleb coined the term “black swan” to describe unusual events that have a large impact. Many investors consider the global financial crisis in 2008-2009, which saw equities decline by over 50% peak-to-trough, to have been a financial black swan. Larry and Kevin note that the 75/25 U.S. total-market equity/five-year Treasury portfolio above would have lost 24.5% in 2008. However, the portfolio consisting of 20% U.S. total market, 20% U.S. small-value stocks and 60% five-year Treasury bonds would have declined just 5.3%. Hence, by adding alternative sources of risk (in this case small-cap and value premia), an investor has the potential to achieve long-term returns that rival those of traditional stock/bond portfolios, and with significantly less exposure to black swan-type losses.
Chapter 4 investigates the results of a recent study by Louis Scott and Stefano Caglia, A Wealth Management Perspective on Factor Premia and the Value of Downside Protection. Using robust simulation techniques, the paper’s authors examined how well factor diversification (including small, value, momentum, and quality) improved expected terminal wealth and the odds of sustaining a retirement portfolio. Larry and Kevin parse the paper’s results and observe that factor exposures helped to mitigate downside risk and improve returns, even when the analysis is conducted on historical factor returns that have been reduced by 50%, to account for overgrazing (i.e., the possibility that returns from exposures to those factors have eroded over time as more assets have been invested in them). The paper also demonstrates that a portfolio of diversified factor exposures would have dominated even a skilled market timer in terms of terminal wealth.
Read the full article here by Adam Butler, Advisor Perspectives
