The Three Factor Model

    When deciding where to place you investments you will always hear buzzwords like diversification and return, but important factors like your or goal for the investment play a big role too. If you are a recent college graduate with 30 years before you will want to retire you will take  a long term approach compared to someone in there upper 50's looking to retire soon. Small Cap stocks offer a greater return on investment than mid and large cap stocks as they have more room to grow but also more risk. Small cap stocks are more volatile but over a 30 year period you experience several market cycles and timing of the market isn't as important. An index fund can diversify this risk while still providing higher return than the market.        

Vanguard Small Cap ETF trades under the ticker VB. Vanguard Small Cap ETF seeks to mimics the investment returns of a small cap index, CSRP U.S. Small Cap index. This diversifies the investment in growth and value. The fund remains fully invested and with low expense to minimize tracking error. VB offers 10 year average annual return of 12.27% with 9.81% return since inception. The top three holdings are WellCare Health Plans, GrubHub, and Veeva Systems with its top ten holdings accounting for less than 3.5% of total investment. The fund has a median market cap of 4.5 billion with a Price to Equity ratio of 19.7. VB has a turnover rate of 14.5% at year end of 2017.

Vanguard Small Cap ETF offers slightly higher average returns than SPY but has a much larger deviation. VB average monthly returns since 2009 is 1.63% compared to 1.44% for SPY, annually the return would be 19.56% and 17.28% respectively. SPY on the other hand has less deviation with a monthly standard deviation of 3.63% compared to that of 4.73% for VB. Vanguard ETF offers slightly higher return than the market as a whole, but has higher fluctuations, which is acceptable for long term investing.  As stated in previous articles the Sharpe Ratio calculates the excess return for the risk taken, since VB has significantly more deviation and therefor risk its Sharpe Ratio is .0034 compared to .0039 for SPY despite better return for VG.

The Capital Asset Pricing Model (CAPM) was developed to calculate whether an investment provides abnormal returns and redefined beating the market. If a fund manager invests in a stock twice as risky as the market and provides returns of only 1.5 times of the market, yeas he provided higher returns than the market but actually has negative abnormal returns and lost to the market as he should have twice the returns for twice the risk. Beta is the measure of systematic risk and cannot be avoided by diversification. Fama and French later published a paper "Beta is Dead" that showed a better model was needed. The model they constructed was the Three Factor Model that uses three factors hence the name. The market factor, the small stock effect, and value stock effect can all be used in the equation to better calculate Alpha, the abnormal return. When running the individual regression for each factor for VB the beta for market is 1.20, SMB is 1.16, and HML is .61 all with significant t-stats above 1.96. When running the regression for all three  together the betas were 1.067, 0.604, and .086 respectively all significant. The average alpha for VD since 2009 until present using the individual regression for the three factor model is -0.35 and with using a regression for all three factors at once an alpha of -.05 which is not economically significant. This return slightly lower than the market can be explained by the management fee Vanguard charges. I recommend that an investor holds both Vanguard Small Cap ETF and SPY. Both offer returns that are close to the market but not abnormal unfortunately, and have insignificant differences between there alphas and Sharpe ratio.