Dimensions of Equity Returns in Europe

RESEARCH Dimensions of Equity Returns in Europe November 2015 Stanley Black, PhD Vice President Research Philipp Meyer-Brauns, PhD Research Size, value, and profitability premiums are well documented in the returns of stock markets around the world. This paper extends the evidence of these cross-sectional return patterns to European equity markets and finds that they are pervasive and persistent in Europe. Investors can seek higher expected returns in well-diversified portfolios that target these dimensions of equity returns. DIMENSIONS OF EXPECTED EQUITY RETURNS A dimension of expected returns identifies systematic differences in expected stock returns. It must be sensible, persistent through time, pervasive across markets, robust to alternative specifications, and cost-effective to capture in well-diversified portfolios. Decades of rigorous theoretical and empirical research have identified four dimensions of expected returns in equity markets: market, company size, relative price, and profitability. The market dimension reflects the premium of stocks over bills. Within equities, there are also differences in expected returns. Securities with smaller market capitalization, lower relative prices, and higher profitability have had higher average returns than those with larger market capitalization, higher relative prices, and lower profitability. There is extensive empirical evidence that these premiums exist in equity markets around the world: See Fama and French (1992, 1993, 1998, 2006, 2012, 2015a, 2015b), Novy-Marx (2013), O Reilly and Rizova (2013). The purpose of this paper is to focus the lens on equity markets in Europe. Have there been market, size, value (relative price), and profitability premiums in European markets similar to those documented for US and aggregated non-us developed and emerging markets? This paper examines 15 European markets generally classified as developed (Austria, Belgium, Denmark,

DIMENSIONAL FUND ADVISORS 2 Finland, France, Germany, Ireland, Italy, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, and the UK) over the period 1982 2014. We show that over the past 30 plus years, there have been market, size, value, and profitability premiums in European markets. EQUITY PREMIUMS Exhibit 1 shows average annual market premiums in each of the 15 markets as well as for the Europe and Europe ex UK regions between 1982 2014. 1 The average premiums were all positive and ranged from 6.5% in Italy to 13.4% in Sweden, among the countries with returns available from 1982. The average equity premium for the European region as a whole was 8.1%. SIZE DIMENSION In this study, we define small cap stocks as those that constitute approximately the bottom 10 12.5% of a country s aggregate market cap ranked on firm size, excluding those with both high relative price and low profitability (data availability permitting). 2 Exhibit 2 shows that the average return premium of small cap stocks over large caps in Europe was 2.4% for 1982 2014, the longest sample for which we have small cap return data available for most European countries. In addition, the exhibit shows that the realized size premium was greater than 2% in 10 of the 15 countries analyzed. Among larger markets, the realized premium was sizable in the UK (3.6%), France (4.8%), and Spain (3.7%), but Exhibit 1 Average Annual European Market Premiums Europe 8.1% Europe ex UK 8.6% Austria 7.7% Belgium 11.1% Denmark 11.1% Exhibit 2 Average Annual European Size Premiums Europe 2.4% Europe ex UK 1.9% Austria 5.8% Belgium 0.7% Denmark 4.2% Finland* 12.9% Finland* 1.2% France 8.9% Germany 8.4% Ireland* 7.4% Italy 6.5% The Netherlands 10.2% Norway 12.1% Portugal* 2.4% Spain 9.1% Sweden 13.4% Switzerland 9.3% United Kingdom 7.7% (GBP, 6.5%) * 1990 2014 due to data availability. Past performance is no guarantee of future results. Filters were applied to data retroactively and with the benefit of hindsight. Returns are not representative of indices or actual strategies and do not reflect costs and fees associated with an actual investment. Actual returns may be lower. 1982 1989 market returns sourced from Fama/French international market index returns where available from Ken French s data library, and from MSCI Standard index returns for Austria and Denmark when Fama/French indices were unavailable. Source: Dimensional, Bloomberg, Ken French s data library, MSCI, Thomson Reuters Datastream, UK Debt Management Office. France 4.8% Germany 0.1% Ireland* 6.0% Italy 1.4% The Netherlands 3.1% Norway 6.0% Portugal* 6.9% Spain 3.7% Sweden 2.3% Switzerland 0.4% United Kingdom 3.6% (GBP, 3.2%) * 1990 2014 due to data availability. See Data Appendix for methodology details starting in 1990. 1982 1989 large cap returns taken from Fama/French international market index returns where available from Ken French s data library, and from MSCI Standard index returns for Austria and Denmark when Fama/French indices were unavailable. 1982 1989 small cap returns are from the Dimensional Europe Small Cap Index. Source: Dimensional, Bloomberg, Ken French s data library, MSCI. 1. To compute the equity premium, we use the Euribor three-month offered rate from December 1998 to December 2014. Before December 1998, we use the German three-month deposit offered rate. For the UK, we use one-month UK treasury bills. Data provided by Thomson Reuters Datastream and UK Debt Management Office. Returns are computed in EUR from 1999 to 2014 and DEM from 1982 to 1998. 2. It has been established in the literature that this segment of the small cap market has not delivered the small cap premium in markets around the world. Since an investor who desires higher expected returns than the market would likely exclude this segment from their portfolio, we exclude it from our small cap index as well.

DIMENSIONAL FUND ADVISORS 3 weaker in Germany (0.1%) and Switzerland (0.4%). A number of the European equity markets are concentrated. Because of this, it is not surprising to see variation in the realized size premium. The realized premium for the European region as a whole, however, was similar to the realized premium in the US 3 (2.4%) and international developed markets (3.2%) over this time period. RELATIVE PRICE (VALUE) DIMENSION Value stocks in Europe showed a sizeable return premium over growth stocks in the data sample. Exhibit 3 shows the value premiums in Europe for 1982 2014. 4 The value premium was positive for Europe (4.9%) as well as each of the 15 individual markets, ranging from 1.5% in Ireland to 7.3% in Sweden. The value premium in Europe was similar to realized value premiums in the US (4.5%) and in international developed markets (6.0%) during 1982 2014. Exhibit 3 Average Annual European Value Premiums Europe 4.9% Europe ex UK 5.6% Austria 7.0% Belgium 5.8% Denmark 4.6% Finland* 4.3% France 6.6% Germany 6.5% Ireland* 1.5% Italy 3.8% The Netherlands 4.6% Norway 7.1% Portugal* 4.1% Spain 6.3% Sweden 7.3% Switzerland 5.1% United Kingdom 3.3% (GBP, 3.2%) * 1990 2014 due to data availability. See Data Appendix for methodology details starting in 1990. 1982 1989 annual value premiums computed from Fama/French international country value and growth indices available from Ken French s data library. Source: Dimensional, Bloomberg, Ken French s data library. PROFITABILITY DIMENSION Exhibit 4 shows the return premium of high profitability stocks over low profitability stocks in Europe from 1982 to 2014. 5 During this period, the average profitability premium in Europe was 3.6%. In addition, the realized premium was greater than 2% in 11 of the 15 countries analyzed. It was negative in just two, Belgium and Finland. As for the size premium, it is to be expected there will be variation in the realized premiums across the countries examined. Profitability premiums in the US (4.4%) and in international developed markets (5.1%, 1991 2014 due to data availability) were comparable in magnitude to the European profitability premium. Exhibit 4 Average Annual European Profitability Premiums Europe 3.6% Europe ex UK 5.4% Austria 4.7% Belgium 2.5% Denmark 5.8% Finland* 0.1% France 2.5% Germany 8.2% Ireland* 11.2% Italy 11.3% The Netherlands 3.3% Norway 6.0% Portugal* 4.4% Spain 6.2% Sweden 0.8% Switzerland 6.5% United Kingdom 1.0% (GBP, 1.1%) * 1990 2014 due to data availability. See Data Appendix for methodology details. Source: Dimensional, Bloomberg. ANNUAL PREMIUMS Although market, size, value, and profitability premiums appear over the full 33-year samples, they are not positive every year. Exhibit 5 shows annual realizations for the market, size, value, and profitability premiums from 3. Size premium for the US is the difference between the Dimensional US Small Cap Index and the S&P 500 Index, international developed markets size premium is the difference between the Dimensional International Small Cap Index and MSCI World ex USA Index (gross dividends). US and international developed markets value premiums available from Ken French s data library. US profitability premium available from Ken French s data library. International developed markets profitability premium is the difference between the Dimensional International High Profitability Index and the Dimensional International Low Profitability Index. 4. Book values and income statement variables necessary to compute the value and profitability premiums were available from 1982 in many countries and 1990 in others. 5. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book.

DIMENSIONAL FUND ADVISORS 4 Exhibit 5 Annual Market, Size, Value, and Profitability Premiums for Europe MARKET PREMIUM 50% 30% 10% 10% 30% 50% 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 SIZE PREMIUM 50% 30% 10% 10% 30% 50% 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 VALUE PREMIUM 50% 30% 10% 10% 30% 50% 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 PROFITABILITY PREMIUM 50% 30% 10% 10% 30% 50% 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 Past performance is no guarantee of future results. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. See Data Appendix for methodology details starting in 1990. 1982 1989 market returns sourced from Fama/French Europe and Scandinavia market indices available from Ken French s data library. 1982 1989 small cap returns sourced from the Dimensional Europe Small Cap Index. 1982 1989 annual value and growth returns sourced from Fama/French Europe and Scandinavia value and growth indices. Source: Dimensional, Bloomberg, Ken French s data library, Thomson Reuters Datastream, UK Debt Management Office.

DIMENSIONAL FUND ADVISORS 5 1982 to 2014 for the Europe region. The tradeoff when pursuing higher expected returns by focusing on the stocks that are expected to provide these premiums is the potential for underperformance relative to the market in a given year. While we believe the expected premiums are positive every day, realized premiums cannot be known in advance and data shows equity markets are extremely difficult (if not impossible) to successfully time. Because of this, maintaining a continuous emphasis on the premiums provides a cost efficient way to pursue the higher expected returns associated with them. PUTTING IT ALL TOGETHER: HYPOTHETICAL CORE STRATEGY EXAMPLE In the previous sections, we documented the dimensions of expected returns in European equity markets: market, size, relative price, and expected profitability. The existence of the size, value, and profitability premiums allows investors in European equity markets to increase the expected return of their portfolios relative to the market by targeting these premiums. Investors should consider integrating multiple dimensions into a single solution in an effort to improve the expected reliability of performance outcomes. The hypothetical core strategy shown below is a marketwide strategy, where each security s target weight is strongly linked to its current price but is allowed to over and underweight to emphasize securities with higher expected returns. Stocks with smaller market capitalization, lower relative prices, and higher profitability are overweighted relative to their market cap weight. Conversely, firms with larger market capitalization, higher relative prices, and lower profitability are underweighted relative to their market cap weight. This hypothetical core strategy balances competing premiums, minimizes unnecessary turnover by design, and is highly diversified. Such an integrated solution can be tailored to meet an investor s expected outperformance goals. However, higher expected outperformance tends to come with increased deviation from the market. To quantify these tradeoffs, we show the results for a hypothetical core strategy that emphasizes securities with higher expected returns. Exhibit 6 reports the simulated historical performance of the hypothetical core strategy vs. a market capitalizationweighted large cap portfolio. Exhibit 6 Large Cap Market and Simulated Core Strategy Returns for Europe in EUR/DEM, 1990 2014 Annualized Compound Return Annualized Standard Deviation Annualized Premium Relative to Large Cap Mkt Annualized Tracking Error to Large Cap Mkt CORE STRATEGY EUROPE LARGE CAP MARKET 8.51% 7.47% 15.51% 15.52% 1.04% 1.94% Source: Dimensional, Bloomberg. Not a live strategy. Data as of December 31, 2014. Simulated strategy returns in EUR based on a model/backtested simulation to demonstrate a broad economic principle. The performance was achieved with the retroactive application of a model designed with the benefit of hindsight; it does not represent actual investment performance. Backtested model performance is simulated (it does not reflect trading in actual accounts) and is provided for informational purposes only. The securities held in the model may differ significantly from those held in client accounts. Model performance may not reflect the impact that economic and market factors might have had on the advisor s decision making if the advisor were actually managing client money. This strategy was not available for investment in the time periods depicted. Actual management of this type of simulated strategy may result in lower returns than the backtested results achieved with the benefit of hindsight. Past performance (including simulated past performance) does not guarantee future or actual results. The simulated performance shown is gross performance, which includes the reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees and other expenses. A client s investment returns will be reduced by the advisory fees and other expenses it will incur in the management of its advisory account. From 1990 to 2014, the annualized compound return for the large market was 7.5% vs. 8.5% for the core strategy. By focusing on the dimensions of higher expected returns, investors could have improved the performance of their portfolios over a broad market benchmark by more than 1% per year. The higher average return of the core strategy in Europe has been achieved with a standard deviation similar to the large cap market, 15.5% from 1990 to 2014. Exhibit 7 shows that the European core strategy did not outperform at the expense of narrower market coverage. It is very well diversified and holds a larger number of securities than the large cap market. The size, relative price, and profitability characteristics of the core strategy reflect the balanced and measured approach this strategy takes when overweighting

DIMENSIONAL FUND ADVISORS 6 Exhibit 7 Selected Simulated Characteristics of Large Cap Market and Hypothetical Core Strategy for Europe as of December 31, 2014 Weighted Average Tcap (EUR) Aggregate Price-to-Book Weighted Average Profitability CORE STRATEGY EUROPE stocks with higher expected returns. They also reflect how the core strategy balances the three complementary dimensions of expected returns to add value. Following on this point, Exhibit 6 also shows the LARGE CAP MARKET 59,628 75,504 1.81 1.83 0.39 0.35 Firm Count 1,453 414 Source: Dimensional, Bloomberg. Not a live strategy. Data as of December 31, 2014. tracking error of the hypothetical core strategy vs. the large cap market. As we emphasize the dimensions of higher expected returns, a tradeoff between higher average premiums and tracking error relative to the market emerges. CONCLUSION There have been market, size, value, and profitability premiums in Europe over the past three decades. Investors can target these dimensions to improve the expected returns of European equities by (1) using multiple dimensions of expected returns and (2) overweighting firms with higher expected returns using a measured, controlled, low-turnover weighting schema that incorporates current price. Reliability of outcomes may be increased by using diverse sources of value added (profitability, relative price, and size) and broad diversification across securities and sectors. Low turnover, combined with that broad diversification, allows for a disciplined and patient approach that helps control implementation costs. REFERENCES Fama, Eugene F. & Kenneth R. French. 1992. The Cross-Section of Expected Stock Returns. Journal of Finance, 47(2), 427 465. Fama, Eugene F. & Kenneth R. French. 1993. Common Risk Factors in the Returns on Stocks and Bonds. Journal of Financial Economics, 33(1), 3 56. Fama, Eugene F. & Kenneth R. French. 1998. Value vs. Growth: The International Evidence. Journal of Finance, 53(6), 1975 1999. Fama, Eugene F. & Kenneth R. French. 2006. Profitability, Investment, and Average Returns. Journal of Financial Economics, 82(3), 491-518. Fama, Eugene F. & Kenneth R. French. 2012. Size, Value, and Momentum in International Stock Returns. Journal of Financial Economics, 105(3), 457 472. Fama, Eugene F. & Kenneth R. French. 2015a. A Five-Factor Asset Pricing Model. Journal of Financial Economics, 116(1), 1 22. Fama, Eugene F. & Kenneth R. French. 2015b. International Tests of a Five-Factor Asset Pricing Model. Fama-Miller Working Paper, http://ssrn.com/abstract=2622782. Novy-Marx, Robert. 2013. The Other Side of Value: The Gross Profitability Premium. Journal of Financial Economics, 108(1), 1 28. O Reilly, Gerard & Savina Rizova. 2013. Expected Profitability: A New Dimension of Expected Returns. Dimensional Fund Advisors Quarterly Institutional Review, 8(1), 4 7.

DIMENSIONAL FUND ADVISORS 7 APPENDIX Data The data used in this paper come primarily from Bloomberg. The study focuses on Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, and the UK. The smallest 0.1% of market capitalization in each market is excluded, and the sample is restricted to exchange traded stocks that meet minimum liquidity and listing requirements. We follow the approach of Fama and French (2015a) and compute the relative price and profitability premiums as the average of the premiums computed separately for large stocks and small stocks, using portfolios rebalanced annually in June. Within each country, large stocks are defined as the top 87.5% of cumulative market cap ranked on firm size and the remaining stocks are classified as small. High and low relative price and profitability portfolios are defined as the top and bottom 25% of market cap within each country s respective size range ranked on price to book or profitability. The portfolios for each country are combined at country market weights to form regional European portfolios and premiums. The S&P data is provided by Standard & Poor s Index Services Group. MSCI data copyright MSCI 2015, all rights reserved. Index Descriptions Dimensional Europe ex UK Small Index was created by Dimensional in April 2008 and is compiled by Dimensional. From 1982 to 1989, the index is a market capitalizationweighted index of small company securities in the eligible markets within the small cap universe. Countries included are Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy, Netherlands, Norway, Spain, Switzerland, and Sweden. Exclusions: REITs and investment companies. Source: Dimensional. Dimensional Europe Small Index was created by Dimensional in April 2008 and is compiled by Dimensional. From 1982 to 1989, the index includes the Dimensional Europe ex UK Small Index and Dimensional UK Small Cap Index combined using small portfolio weights. Countries included are Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy, Netherlands, Norway, Spain, Switzerland, Sweden, and the UK. Exclusions: REITs and investment companies. Source: Dimensional. Fama/French Europe and Scandinavia Growth Index 1982 1989: Fama/French Europe Growth Index and Fama/ French Scandinavia Growth Index combined at regional market weights. Provided by Fama/French from MSCI and Bloomberg securities data and available at http://mba.tuck. dartmouth.edu/pages/faculty/ken.french/data_library.html. Fama/French Europe and Scandinavia Market Index 1982 1989: Fama/French Europe Market and Fama/ French Scandinavia Market Index combined at regional market weights. Provided by Fama/French from MSCI and Bloomberg securities data. Fama/French Europe and Scandinavia Value Index 1982 1989: Fama/French Europe Market Index and Fama/ French Scandinavia Value Index combined at regional market weights. Provided by Fama/French from MSCI and Bloomberg securities data. Fama/French Europe and Scandinavia ex UK Growth Index 1982 1989: Fama/French Europe ex UK Growth Index and Fama/French Scandinavia Growth Index combined at regional market weights. Provided by Fama/French from MSCI and Bloomberg securities data. Fama/French Europe and Scandinavia ex UK Market Index 1982 1989: Fama/French Europe ex UK Market Index and Fama/French Scandinavia Market Index combined at regional market weights. Provided by Fama/French from MSCI and Bloomberg securities data.

DIMENSIONAL FUND ADVISORS 8 Fama/French Europe and Scandinavia ex UK Value Index 1982 1989: Fama/French Europe ex UK Value Index and Fama/French Scandinavia Value Index combined at regional market weights. Provided by Fama/French from MSCI and Bloomberg securities data. Fama/French International Country Growth Indices 1982 1989: Fama/French International Country Growth Indices. Provided by Fama/French from MSCI and Bloomberg securities data. Fama/French International Country Market Indices 1982 1989: Fama/French International Country Market Indices. Provided by Fama/French from MSCI and Bloomberg securities data. Fama/French International Country Value Indices 1982 1989: Fama/French International Country Value Indices. Provided by Fama/French from MSCI and Bloomberg securities data. This information is provided for registered investment advisors and institutional investors and is not intended for public use. Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission. Dimensional Fund Advisors Canada ULC is a subsidiary of DFA Canada LLC, which is a subsidiary of Dimensional Fund Advisors LP. Past performance is no guarantee of future results. International investing involves special risks such as currency fluctuation and political instability. Investing in emerging markets may accentuate these risks. Diversification does not protect against loss in declining markets. There is no guarantee strategies will be successful. Eugene Fama and Ken French are members of the Board of Directors for and provide consulting services to Dimensional Fund Advisors LP. Robert Novy-Marx provides consulting services to Dimensional Fund Advisors LP. The following persons listed as references are employees of Dimensional Investment LLC, a subsidiary of Dimensional Fund Advisors LP: Gerard O Reilly and Savina Rizova. All expressions of opinion are subject to change. This information is intended for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services. RM48827 11/15