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Posted by & filed under Economics & Markets, Security Selection & Market Timing, Wealth Management.

Since its inception on March 9, 2003, RSP has returned 193%. At the same time, SPY has only returned 97%. This is extremely puzzling as both RSP and SPY hold the same S&P 500 stocks.The only difference is that SPY is a cap-weighted fund and RSP is an equally-weighted one. This begs the question, is RSP’s outperformance normal; and more importantly, is it likely to continue?

To answer the question I asked my intern Nahae Kim to run a regression based on the Nobel Prize winning Fama-French Three Factor Model.

R(x) – rf = alpha + beta1*(Rmkt – rf) + beta2*SML + beta3*HML

Where R(x) is the return of the selected fund, x being either RSP or SPY, alpha is the “skill” of the fund, beta1 is the market risk loading, beta2 is the small cap risk loading and beta3 is the value risk loading.

Here is what I got from the two regressions.

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x = RSP

 

Coefficients

Standard Error

T-Stat

alpha

0.00020216

0.079515306

0.00254

beta1

1.09513796

0.021611333

50.6742

beta2

0.14405660

0.039147475

3.67984

beta3

0.12852667

0.035946467

3.57550

x = SPY

Coefficients

Standard Error

T-Stat

alpha

-0.03390073

0.022912377

-1.479581

beta1

0.99858269

0.006227317

160.3552

beta2

-0.14290451

0.011280365

-12.66842

beta3

0.01678824

0.010357993

1.620800

Let’s analyze the data!

  • RSP’s beta1 is 1.095, that is higher than SPY’s 0.999. This means RSP is taking about 9.6% more market risk.

  • RSP’s beta2 is 0.144. This is much higher than SPY’s -0.14. This means RSP is taking small cap risk while SPY is avoiding any small cap risk.

  • RSP’s beta3 is 0.129. This is also much higher than SPY’s 0.0167. The t-stats especially show a large difference of 3.57 vs 1.62. This means RSP has statistically significant value risk, while SPY has statisticallyinsignificant value risk.

  • While RSP’s alpha is positive and SPY’s alpha is negative, they are both statistically insignificant.

In summary, the outperformance of RSP is due to it taking more risks. Now there is absolutely no puzzle to it! Going forward RSP will likely continue to outperform SPY simply because more risk means more reward.This is a simple truism of the capital market.

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