By Wes Crill, PhD, Dimensional Fund Advisors
Research shows that diversified equity portfolios can pursue higher-than-market returns by systematically emphasizing stocks with certain characteristics, such as smaller market capitalization, lower price-to-book, and higher profitability. The potential for higher returns sounds nice, but investors may be wondering what tradeoffs this entails.
If the concern is higher volatility than the market, investors may be comforted by what the data tell us. A marketwide U.S. stock index emphasizing small cap, value, and high-profitability stocks, such as the Dimensional US Adjusted Market 2 Index, had higher returns than the Russell 3000 Index but a similar standard deviation from January 1979 to June 2024. And pursuing these premiums has not amplified market downturns—the worst 12-month and 36-month returns were similar to those of the Russell 3000 Index.
The primary tradeoff is tracking error, or the extent to which short-term returns differ from the market. Emphasizing stocks with higher expected returns can lead to underperformance relative to the market when premiums associated with these stocks are negative. For example, the worst 12-month period for relative return saw the adjusted market index lag the Russell 3000 Index by about 13 percentage points (0.52% versus 13.54%).
To be clear, potential for deviations from the market is a consideration, but similar volatility to the market implies that pursuing premiums doesn’t have to widen the range of outcomes for investment performance.
Exhibit 1
Volatility vs. Tracking Error
January 1979–June 2024
Past performance is not a guarantee of future results. In USD. Index data provided by Dimensional and Russell. Returns and standard deviations are annualized. The Dimensional indices represent academic concepts that may be used in portfolio construction and are not available for direct investment or for use as a benchmark. Index returns are not representative of actual portfolios and do not reflect costs and fees associated with an actual investment. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.
This article originally appeared in Above the Fray, a weekly newsletter for Dimensional clients.
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