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 The two-asset risk/return frontier is a classic graph. It conveys information which displays the “price of return” better than any other graphing technique.
A 27-year two-asset frontier map from 1980 through 2006 is presented in Figure 1. One asset is the Lehman Brothers Aggregate Bond Index and the other is the Standard & Poor's 500 Index. A 100 percent investment in the bond index (dark blue dot) had an average annualized return of 9.1 percent and a standard deviation of return of 7.5 percent over the 27 years from 1980–2006. The next dot (pink) represents a 10 percent allocation to the S&P 500 Index and a 90 percent allocation to the bond index. Return improves and risk is reduced.
The far right side of the frontier represents a 100 percent commitment to the S&P 500 Index (red dot). This allocation produced a 27-year average annualized return of 13.3 percent with a standard deviation of return of 15.8 percent. An all-stock portfolio generated a 420 bps return premium over bonds, but at the price of 830 bps greater volatility in annual returns. Thus, every basis point of added return came at the “price” of 2 additional basis points of volatility.
A 60 percent equity/40 percent bond portfolio (magenta dot) generated a 27-year annualized return of 11.9 percent with a standard deviation of return of 10.6 percent—representing a return premium of 280 bps over bonds but with only 310 bps more volatility than bonds. The risk/return characteristics of a 60 percent equity/40 percent bond portfolio is nearly a one-to-one trade-off, meaning that each additional basis point of return over the return of an all-bond portfolio produced one additional basis point of volatility (or “risk”).
While the Lehman Brothers Aggregate Bond Index is a reasonable approximation of the overall U.S. bond market, the S&P 500 represents a limited perspective of the U.S. equity market. As a large-cap blend index, it does not represent the distinctly different return patterns of large-cap value or large-cap growth stocks. Moreover, it does not capture the performance of mid-cap or small-cap stocks. In spite of this, the S&P 500 is nearly universally chosen to represent “the” U.S. equity asset class in such a graph.
This paper introduces several new versions (or views) of a two-asset frontier using six additional U.S. equity asset classes (beyond the S&P 500 Index). The six include large-cap value, large-cap growth, mid-cap value, mid-cap growth, small-cap value and small-cap growth (see Figure 2).
As shown in Figure 2, value-based indexes—particularly mid-cap and small-cap—significantly outperformed the S&P 500 Index in both raw return and on a risk-adjusted return basis over the 27-year period from 1980–2006. Growth indexes, on the other hand, underperformed the S&P 500 Index on a risk-adjusted basis and on a raw-return basis.
The performance of small-cap growth is particularly interesting. Its 27-year annualized return of 10.68 percent was only 158 bps higher than the return of the LB Aggregate Bond Index, but small-growth U.S. equity had a standard deviation of return three times higher than bonds (see Figure 3).
The annual returns of each index (LG, LV, MG, MV, SG, SV) represent the average performance of two separate index providers, Dow Jones and Wilshire (Wilshire is presently known as Dow Jones Wilshire). For example, in 1982, the Dow Jones Large Value Index's return was 23.26 percent, while the Wilshire Large Value Index had a return of 17.68 percent. The average of the two LV indexes in 1982 was 20.47 percent, as shown in Figure 3. Each annual return for each of the six separate style box categories was calculated accordingly for the 27-year period.
Figure 4 shows the decade of the '80s. The 10 years from 1980–1989 was a stellar decade for value-based U.S. equity indexes as demonstrated by the northwest-quadrant-seeking MV, LV and SV frontiers. Growth indexes, particularly small-cap growth, generated far worse risk-adjusted performance compared with the S&P 500 Index. Notice how high the origin point (i.e., 100 percent bond portfolio) is on the Y-axis. The 10-year annualized return for the 100 percent bond portfolio was over 12 percent, while a 100 percent S&P 500 portfolio averaged nearly 18 percent.
The decade of the '90s was a very different story (Figure 5). It was a period in which growth-based equity indexes generally provided superior risk-adjusted return compared with value-based U.S. equity indexes. However, they were all outperformed by the S&P 500 Index. No wonder the growth of index funds (most of which were and are based on the S&P 500) was meteoric during this decade.
As an example, Vanguard Index 500 (VFINX) had net assets of $2.2 billion at the end of 1990. By the end of 1999, its assets had surged to $105 billion, representing an increase of over 4,600 percent.
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