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Capturing the Small Cap and Value Risk Premiums

At Shearwater Capital, we derive our investment strategies from leading thinkers in the academic finance community. Our approach to equity investing is largely based on the three-factor model developed by Eugene Fama and Kenneth French. 1,2 According to this model, the expected return of a broadly diversified investment portfolio is determined by the portfolio's exposure to three risk factors: 1) stocks (vs. bonds); 2) small cap stocks; and 3) value stocks.

Fama and French observed that over long time periods, stocks are riskier than bonds and have higher expected returns. They also noted that small cap and value stocks tend to outperform large cap and growth stocks, respectively. Investors should therefore be able to increase their expected returns by holding small cap and value stocks in greater than market proportions.

It is important to realize that the returns of small cap and value stocks can vary substantially from one year to the next. Although equity portfolios that are overweighted in these asset classes have outperformed the overall market in the long run, there is great variability from year to year:

Small Companies vs. the Overall Market

1930 1940 1950 1960 1970 1980 1990 2000

Value Companies vs. the Overall Market

1930 1940 1950 1960 1970 1980 1990 2000

These charts illustrate that U.S. small cap and value stocks have beaten the overall market more often than not. From 1927 to 2006, small cap stocks outperformed the overall market by an average of 2.1% per year. Small cap value stocks did even better with an average annual return of 14.5%, beating the market by 4.2% per year. However, 2007 was one of those years when small cap and value stocks underperformed the overall market:

U.S. Stock Market Index 2007 Annual Return S&P 1500 (overall market): 3.60% S&P 500 (large cap stocks): 5.49% Russell 2000 (small cap stocks): -1.57% Russell 3000 Value Index (value stocks): -1.01% Russell 2000 Value Index (small cap value stocks): -9.78%

At Shearwater Capital, we strive to capture the small cap and value stock risk premiums by emphasizing these asset classes in our client accounts. We do this by constructing broadly diversified portfolios primarily using DFA funds that are designed to capture these risk premiums in an efficient manner. This approach requires patience and discipline because it can lag the overall market in any given year. However, it is also an approach that should reward investors with higher returns in the long run.

As always, please do not hesitate to contact me if you have any questions or comments.

Jeffrey J. Brown, MD MBA CFA Principal, Shearwater Capital

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