The Noise in Short-Term Performance

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By Wes Crill, PhD, Head of Investment Strategists and Vice President, Dimensional Fund Advisors

As a parent of identical twins, I’m well versed in the phenomenon of two lookalike entities exhibiting vast dispersion in behavior at any given time. So, when I encounter substantial short-term performance differences between investment strategies in the same asset class, I am disinclined to infer one is better than the other without more information.1 Indeed, even strategies with nearly identical construction rules and long-run average returns can deviate meaningfully through time. The lesson for investors is to remain cautious, as always, when interpreting past performance.

Matching Pairs

US small cap value research simulations rebalanced in different months provide perspective on the variation in outcomes arising from minute changes in methodology. Average monthly returns in Exhibit 1 reveal an 11 basis point range in long-run performance depending on the choice of rebalance month, despite identical stock selection criteria, a point we’ve used to highlight the need for caution when interpreting simulated outperformance. But even the simulations with the same long-run average returns have diverged markedly over shorter periods.

EXHIBIT 1

Family Ties2Family Ties

Take, for example, the February and November versions, which would appear to be the investment version of monozygotic siblings with average returns identical to two decimal points, 1.53%. And yet, over short periods, these simulations can look more like distant cousins. Rolling one-year return differences, illustrated in Exhibit 2, have fluctuated wildly through time. The magnitude of the difference has averaged 2.80% and frequently exceeded 5%. Some of the return deviation spikes have coincided with periods of high cross-sectional dispersion in US stock returns—in fact, the correlation between the return spread of the small cap value simulations and US market cross-sectional dispersion has been 0.48.3 Turbulent times in markets can magnify contributions from even slight differences in portfolio composition, and that has been true for this pair.

EXHIBIT 2

Perfect Strangers?

Rolling 12-month absolute return difference between US small cap value simulations rebalanced in February and November, December 1975–December 2020

Perfect Strangers?

Given the range of outcomes for such similarly constructed simulations, it should be no surprise we observe short-term dispersion between commercial small cap value indices, even ones with nearly identical names. Average calendar year returns for the MSCI USA Small Value Index (gross div.) and the MSCI US Small Value Index (gross div.) from 1998 through 2020 were close, at 10.04% vs. 9.97%, respectively. But calendar year observations illustrated in Exhibit 3 have on occasion revealed meaningful deviations in performance. The average annual magnitude of the return spread between these indices was 2.11%, maxing out at over 13% in the year 2000.


EXHIBIT 3

Family Matters

Calendar year returns for the MSCI USA Small Cap Value Index (gross div.) and the MSCI US Small Cap Value Index (gross div.), 1998–2020

Making a Short Story Long

Noise in returns limits the usefulness of short-term performance in manager evaluation. Because even minute, arbitrary differences between investments can drive huge differences in realized returns, eye-catching short-term relative performance observed in the past may offer little insight into expected value-add. Longer-term results, particularly when achieved across a suite of investment strategies, offer a more reliable evaluation framework. Investors should also consider the manager’s investment process—a robust process built on decades of expertise can add value that is observable without looking to noisy market returns.


FOOTNOTES

If any of my children are reading this, I think you are all equally great.
2 Simulated data for research purposes only. This does not reflect actual performance of a live or proposed strategy. Results of an actual account may vary significantly. Simulated returns are hypothetical, are subject to numerous limitations, and do not reflect costs or fees associated with an actual investment. Source: Dimensional, using CRSP and Compustat data. Simulations include small cap value firms, excluding lower profitability firms. Small cap is defined as approximately the bottom 8% of the market capitalization. Value represents the bottom 35% of the market capitalization within small caps based on price-to-book ratio. In addition, simulations exclude firms with high year-on-year asset growth, up to 5% of eligible small cap universe by market cap, and consider momentum. No sector constraints are applied. Each simulation is rebalanced annually in a different month.

3
 Based on monthly observations for trailing 12-month return spread and trailing 12-month average of monthly cross-sectional standard deviation of US stock returns from December 1975–December 2020. US stock sample formed each month using data from CRSP and includes all common US stocks (share codes 10 and 11) listed on the NYSE, AMEX, and NASDAQ exchanges with non-missing monthly return data.

Equius Partners is a Registered Investment Advisor. Please consider the investment objectives, risks, and charges and expenses of any mutual fund and read the prospectus carefully before investing. Indexes are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.

Past performance is not a guarantee of future results. This information is provided for educational purposes only and should not be considered investment advice or a solicitation to buy or sell securities. There is no guarantee an investing strategy will be successful. Investing involves risks, including possible loss of principal. Diversification does not eliminate the risk of market loss.

© 2021 Equius Partners, Inc.

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