Jul 29, 2009
John Cochrane* has suggested that the historical premiums for small cap and value stocks reflect "narrowly held risks" and that these premiums are likely to shrink in the future "until the markets have reached equilibrium, in which every investor has bought as much risk as he likes." Do you agree, and, if so, what are the implications for investors considering a small cap or value tilt in their portfolios? 

*"Portfolio Advice for a Multifactor World", Economic Perspectives, Federal ResereveReserve Bank of Chicago, 1999

EFF/KRF: Cochrane offers this notion of narrowly held risks as one of several explanations for the size and value premiums. The premise is that until the last couple of decades, individual investors had limited access to diversified portfolios of small stocks and value stocks. As a result, the prices of small and value stocks were lower than they would be if all investors had easy access, and their expected returns were higher. The introduction and growth of mutual funds that invest in small-cap and value stocks would then reduce the expected returns on these securities.

As a logical proposition this argument is true. Since expected security returns depend on supply and demand, an increase in the average allocation to small and value stocks will reduce the size and value premiums. The premise of the argument, however, is not consistent with the data. There is no evidence that the portfolio of all US equity mutual funds has become increasingly tilted toward small and value stocks over time. The aggregate portfolio still looks a lot like the market portfolio. (See our "Why Active Investing Is a Negative Sum Game.".)

Eugene F. Fama
The Robert R. McCormick Distinguished Service Professor of Finance at the University of Chicago Booth School of Business
Kenneth R. French
The Roth Family Distinguished Professor of Finance at the Tuck School of Business at Dartmouth College
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