Factor investing is the idea that you should not only diversify your portfolio by holding many different securities (stocks and bonds) within each asset class in the portfolio, but also that you should spread your bets among the various “factors” that explain past stock market returns. Some of these factors include:
- Small
- Value
- Momentum
- Quality
There may be hundreds of factors that have been “discovered” by data-mining the limited retrospective data set that is the history of the world's financial markets. The two most popular of these are the small and the value factor. They are so popular that entire mutual fund companies have been designed around them and economists have been awarded Nobel prizes based on their work with them. Naturally, there are lots of people that believe in and don't believe in factors, causing this to be a controversial area of investing. What is certain, however, is that in the past and over the very long term (in our limited data set), small and value stocks have outperformed large and growth stocks. Obviously this is retrospective data, with all of the limitations that entails, and it is entirely possible that it is simply an artifact of the process. But the data is fairly robust, persistent across many time periods and countries in the world.
Believers in Factor Investing
Many smart people, including:
believe that small value stocks are highly likely to outperform the rest of the stock market over the very long term. Of course, nobody really knows why.
Why Does Small-Cap Value Outperform?
There are two basic explanations, the “risk story” and a behavioral bias.
The risk explanation is simply that small value stocks are riskier than other stocks. The companies are not very large and may rely on a single product or service. As value stocks, they are also generally not leaders in their industry and are more likely to go out of business than growthier stocks of the same size in the same industry.
The behavioral bias was perhaps explained best by MoneyChimp and Bill Bernstein. Basically, small value stocks are boring but profitable. Nobody is going to brag at a cocktail party about their small value stock performance. People either want Google or Amazon (or better yet the next Google or Amazon.) I mean, maybe Exxon or Wal-mart is okay, but nobody is interested in a small-cap company like AptarGroup Inc, even if they are a world leader in the global dispensing solutions industry.
Bill Bernstein argues that small growth stocks have the lowest historical returns (as displayed below) due to the lottery ticket effect (as explained above).
Theoretically, there are some people out there that are total believers in small-cap value tilting. They put all their equities into small-cap value stocks (and perhaps offset them with a higher than normal allocation to safe, short-term treasury bonds in what is known as the Larry Portfolio). There is obviously some risk there, given that only 2% of the overall stock market lives in that box.
The Total Stock Market Fund
Then there are people who don't believe in tilting their portfolio at all toward small value stocks. They believe that decreases your diversification, increases your costs, and makes it difficult for you to stick with your portfolio due to tracking error with the overall market.
However, that leaves a lot of people in between those two points on the spectrum. These folks are the tilters, and I'm one of them. They tilt their portfolio toward small value stocks, essentially making a bet that small value will outperform, but without betting the farm. It's really important you don't tilt more than you believe, of course, because the worst thing you can do (assuming a small value tilt will pay off in the long run) is bail out of a small value tilting strategy just before it pays off.
In my case, my US stock portfolio looks like this:
- 25% Total Stock Market Index Fund
- 15% Small Cap Value Index Fund
Yes, I know those two numbers don't add up to 100%, but that's because my portfolio also has 20% international stocks (split 15% large, 5% small), 20% real estate, and 20% bonds. That's actually a pretty decent tilt. Let me demonstrate, again using the Morningstar Instant X-ray tool. Remember, the graph above is a portfolio that is 100% US Total Stock Market. This one is a 100% Small-Cap Value Index Fund, at least the Vanguard version of such.
Vanguard Small-Cap Value Fund
As you can see, even a “100% small-cap value” portfolio isn't 100% small-cap value, but it does have 12X as much in small-cap value stocks as the overall market, along with 4X as much in mid-cap value stocks, 9 times as much in small blend stocks, and 3.7X as much in mid-cap blend stocks. There are, of course, even smaller and more valuey funds out there, such as
The DFA Small-Cap Value Fund
which is obviously much smaller and more valuey. You can get even more extreme with
The S&P 600 Value ETF (RZV)
If you prefer one of these funds, you can get to the same weighting using less of it. In my case, I use the Vanguard Small-Cap Value fund because it is convenient, widely available, and very cheap. I just use a little more of it to make up for the fact that it isn't as small and valuey as other options. But if you take my portfolio, 25% Total Stock Market and 15% Vanguard Small Value, the x-ray looks like this:
My Portfolio
So I have 5 times as much in small value, 4 times as much in small blend, 2X as much in mid value, and 2X as much in mid blend as the overall market. That's about as much as I'm comfortable with in the long run, because I know there is at least a small chance that this bet will not pay off over my six-decade investing career. However, it is a bet I am willing to make. If you have also made this bet, I would caution you not to change it now. If you have not made this bet, I would suggest you at least consider doing so.
The Case for Small-Cap Value NOW
Let me explain why I think small-cap value is still a smart, long-term bet.
# 1 Recent Small Value Performance Sucks
Small value has outperformed the overall market in the long run. But in the recent past, which is now a substantial period, it has underperformed the market. Our natural tendency as investors is to performance chase, that means we buy what has done well recently and sell what has not done well recently. Unfortunately, this natural tendency often works to our detriment as we end up repeatedly buying high and selling low, abandoning a strategy just before it has its next day in the sun as most strategy and asset classes eventually do. Let's consider just how poorly small value has done recently. This data was taken from Morningstar on 4/14/2020.
As you can see, small value performance has been terrible for basically my entire investing career. It's been terrible recently and it's been terrible for quite a long time. Even going back all the way to 2005, it's underperforming the overall market by over 2% a year! That's massive underperformance.
So that leaves you to decide what is most likely to happen going forward. There are four possibilities:
# 1 Small value will underperform the market forever. Obviously, if this were to occur, you would not only want to avoid tilting to small value, but you would want to actively bet against it.
# 2 Small Value will continue to underperform for a while. If this occurs, the best thing to do is avoid small value for a while. This is difficult to do because it requires you to time the market.
# 3 Small Value will now perform similarly to the market going forward. If this occurs, it does not matter if you tilt toward small value or not, you'll end up with essentially the same thing (minus any difference in expenses).
# 4 Small Value will “return to the mean” and now outperform the market for a while, most likely quite dramatically. If this occurs, you'll be glad you overweighted small value.
Consider the likelihood of each of these four scenarios, given where we are at today. While there is no guarantee of a return to the mean, a review of the data would suggest that it is the most likely outcome.
# 2 The Gambler's Fallacy Does Not Apply
It isn't that small value is just “due.” This is known as the Gambler's Fallacy. Imagine you're at the roulette table and the ball has stopped on black seven times in a row. A gambler might say that red is now “due”, but the truth is that the next spin is no more likely to land on red than it is to land on black. That is not the case with small value stocks because it isn't a random event. Every time small value underperforms the overall market, it becomes more likely to outperform in the future because its valuation goes down. Essentially, you can buy a dollar of earnings for less and less money every time it underperforms. The worse it does, the better deal it becomes. Consider this chart conveniently compiled by Franklin Templeton and published on Seeking Alpha:
On the X-axis, we have all the years since our last major crisis in 2008. On the Y-axis, we see the relative price to earnings ratio of small value to large value. As you can see, at the peak in 2012, you were paying 27% more for a dollar of earnings from a small value company as you were for a dollar of earnings from a large value company. That has since reversed and as of the end of 2019, you were paying 12% less for a dollar of earnings from a small value company, on average. A comparison of small value stocks to large growth stocks would likely be even more impressive.
# 3 Beware Cherry Picking Time Periods
Under # 1, I demonstrated terrible short to medium term performance for small value compared to the overall US market. What happens if you add just a few more years to that analysis? Instead of stopping in 2005, go back to 2000. Again courtesy of Franklin Templeton, we have the answer:
From 2000 to 2005, small value performed so well that it overcame the underperformance of the entire last 15 years and then some. Performance is very dependent on the time period selected. Remember that post I did a while back on the Periodic Table of Investing? If you look at those tables in that post, you'll see that I have data on small value from 1988 to 2007. After 2005, I use the actual data from the Vanguard ETFs. Let's reproduce it all here in a form that is easy to read.
I have marked the better performing asset class in red. As you can see over this 32 year period, small value beat the market 17 times, slightly more than half of the time. Overall, $10,000 invested in 1988 in the overall market turned into $270,109 and $10,000 invested in small value turned into $337,330. The overall annualized returns were:
- Total Stock Market: =RATE(32,0,-10000,270109) = 10.85%
- Small Value: =RATE(32,0,-10000,337330) = 11.62%
But what I mostly want to point out with this data is that the pendulum swings back and forth. Let's just quickly graph the differences in return over the years.
Everything above 0% shows overall market outperformance. Everything under 0% shows small value outperformance. Counting 2020, 6 of the last 7 years small value has underperformed. After looking at this chart do you really want to bet on that trend continuing going forward? I don't, and in fact, I haven't. I want you to particularly look at the years AFTER a major crisis, 1991-1993, 2003-2006 and 2009-2013. Small value won all of those years. I can't tell you when our current crisis will end, but when it does, I would expect good things from small value stocks.
# 4 Overperformance Generally Follows Underperformance
Let's go back even further. Eric Nelson is a financial advisor, a huge fan of factor investing, and a frequent commenter on this blog. He wrote a piece recently about this topic entitled Small Value Down But Not Out. He compared a portfolio composed of the S&P 500 stocks to one which was tilted to large and small value stocks and looked at all the 10 year rolling periods since 1928. So 1928-1937, 1929-1938, 1930-1939 etc. What he found was that the tilted portfolio outperformed in 82% of those time periods and by an average of 2.8%. But the more impressive finding was that if you look at the 18% of periods when the tilted portfolio underperformed, the average outperformance in the NEXT 10 years was +4.9%. He made this chart using DFA funds. Take a look at the “lost decade” of the 2000s and compare it to the 2010s.
Now ask yourself if you think the next decade is going to be more like the 2000s or more like the 2010s.
My Argument
My point in writing this post wasn't to try to convince you to tilt your portfolio. I think there are very strong arguments that can be made for a total market-based portfolio without any tilts. However, I also think there are strong arguments that can be made for a tilted portfolio. My own portfolio reflects my ambivalence on this topic (heavily small value tilt on the domestic side and a more moderate small-only tilt on the international side).
My point in writing the post was to show that NOW is not the time to change from a small-value-tilted portfolio to a non-tilted portfolio. In fact, I would argue that it is just the opposite. If you really think you want a tilted portfolio for the long-term going forward, now would be a pretty good time to implement it.
Most importantly, it is critical to realize that implementing a tilted portfolio is a life-long decision. Even 10-15 years is considered short-term when it comes to decisions like these. If you are not convinced that a small value tilt is going to pay off in the long run, you will be unlikely to be able to maintain the portfolio through periods of time like the last 15 years when it underperforms. This is unlikely to be the only period of underperformance you will see in your lifetime with this strategy. Don't tilt more than you believe and if you do tilt, tilt for the rest of your life.
What do you think? Are you a tilter/slice and dicer? If so are you sticking with your strategy or have you changed it? Comment below!
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I would caution people against adding small value right now. The time might be right. Or not. But times of abnormal markets and emotional stress are not times to make portfolio changes.
For over 20 years I have “tilted” my portfolio to Value stocks, and some to Small-cap. I came out slightly ahead because of that.
I do think I saw more volatility, particularly in my small value stocks and funds.
It makes sense that higher returns come with more “risk” AKA volatility.
I began “derisking” my portfolio a few years ago. I added more bonds and shifted stocks more to the total market.
It is all more stable and easier now.
It comes down to personal preference. Are you okay with the market price of your assets going up and down a lot? Are you okay with having the S&P 500 do much better than you are some years? Are you sure you won’t need to sell any of those stocks soon, etc?
There is no one magic bullet. It all goes back to having a plan (IPS).
You should take a look at Vanguard’s Factor ETFs as well; I have transitioned my SCV holdings from VBR/VIOV to VFMF instead and TLH back and forth as well.
Lots more moving parts in that ETF than just value. It has a momentum screen, a quality screen, and a volatility screen.
Do you think there’s a time in which it is too late to make it worthwhile to add-in small-cap value? For example, if I plan to retire in 5 years and live off my pension and investments, is SCV less appealing for someone like me? BTW, I have roughly 7.5% of my spouse’s and my portfolio in Vanguard REIT index funds (in Roth IRAs) and have been thinking of changing my IPS to eliminate REITs in favor of SCV, thus moving my 7.5% from one to the other. Your post is timely.
I don’t think it’s too late no. But make any portfolio changes slowly and with great thought. It’s easy to performance chase when doing that, although most would say that adding small value now isn’t performance chasing!
In fact as you approach retirement in a good to time to add in small cap value. It’s not possible to time factors, including the market factor (total market funds). So by diversifying across factors you are hedging against the risk that any one of them might underperform just as you start retirement. Eg. If you retired in 2000 with a total market portfolio, you suffered a big drawdown. At that time small cap value performed extremely well and smoothed the ride considerably. Of course you must have a good understanding of factor investing, and be able to tolerate the tracking error. For that have a look at Larry Swedroe’s book on factor investing.
Great article and a good reminder to stay the course! I currently have a small/value tilt on my portfolio, although slightly less aggressive than the WCI. (4x small value, 3x small blend) What I find interesting is the significant difference between the different small/mid value funds. I currently hold both a mid value ETF (IJJ) and a small value ETF (IJS) through ishares. When looking at morningstar though, my mid value ETF seems comparable to Vanguard’s small cap value fund.
Anyone know of a good website that compare’s small/mid value funds? I’ve been wanting to tax loss harvest on either in the past, but haven’t felt comfortable in doing so due to the differences between the vanguard, ishares, schwab funds.
How about Morningstar.com?
What is equivalent mutual fund to track small cap value tilt ?
newb question here: does this concept this apply when comparing a 2045 retirement fund ($20/share) vs a large cap US stock index fund($210/share)? I know that retirement funds gradually shift over to bonds as they age, and is not an index fund, but does the reasoning above apply? Thanks.
The price per share doesn’t matter at all.
Those are fairly different funds. One has international stocks and has bonds and has mid-cap and small-cap stocks. The other just has large cap US stocks.
Following up on Henir’s question – is it easier to earn a profit from stocks with a lower price per share than one with a higher price per share?
No, it doesn’t matter. 10 shares at $100 a share or 100 shares at $10 a share. Same, same.
Does anyone find that tilting makes it harder to tax loss harvest? Less similar but not exact quality funds?
More opportunities to tax loss harvest due to more funds, but fewer good options for sure.
But bear in mind that only things I tax loss harvest are TSM, TISM. and small international. My other holdings are in tax-protected accounts. I’ve never tax loss harvested small value because I’ve never had it in taxable.
So suppose you began investing in those 3 funds at the start of a bull market and a subsequent bear market would still have you at an overall gain. You would just never have the opportunity to tax loss harvest? I would think it might pay to invest in a new index fund every few years just to avoid that situation
Why, were you under the impression that you can’t tax loss harvest recently purchased shares of those funds just because some of your shares are still above water?
What is equivalent mutual fund to track small cap value tilt ?
Not sure what you’re asking. I use the Morningstar Instant X-ray Tool to measure how much tilt I have.
The fund/ETF I use for small value is the Vanguard one (VBR).
I hate to be the contrarian here but you guys are little too gung-ho on the stock market. Try reading the New York Times article, “Bonds Beat Stocks Over the Past 20 Years.” Over the past 20 years, the S&P returned 5.4% and the 30 year treasury bond returned 8.3%. Even junk bonds did better at 6.5%. The massive federal and private debt, not to mention, the current fed balance sheet should give people pause. Don’t get me wrong, bonds may not be the best investment going forward either. Stocks and bonds are both not cheap at this point. The “Stocks for the Long Run” mantra may work if you are in your 30s or 40s but when you are close to 60 you have to be cautious. In the long run we are all dead. I remember the 1970s well. Both stocks and bonds were bad then. Try reading columns by market veterans like David Rosenberg, Gary Shilling, Dennis Gartman and Lacy Hunt. These guys have seen a lot of markets and they are not painting a pretty picture here. I agree that nobody knows the future for sure but it is a good bet that we are in for a deep recession again (think back to the crashes of 2000-2002 and 2008). This present debacle could be followed by inflation or possibly stagflation. Physicians need to SAVE more. As a group we earn 250-300K plus per year. Americans spend about an average of $60,000 per year after taxes. As physicians we can easily save more than 40% per year during these rough times. Keep your powder dry. Don’t be too anxious to invest in the stock market during these turbulent times. Yes, small cap and emerging stocks are cheap but they probably will get a whole lot cheaper in the near future. Is this market timing? Yes, but whenever times change we all have make adjustments. I’m going to be 64 years old this year. I was about 60% in stocks at the beginning of this year with tight stops because I felt that stocks were pricey. Only handful of stocks such as Google, Microsoft and Amazon were dragging the indexes up. My stops on my ETFs (VTI, VXUS, etc.) triggered at the end of February. Since then, I have been barbelling TLT and GLD with stops and cash in the middle. I recently bought some oil stocks, as dismal as the industry is, when the USO went below zero because I figured that despite the oil glut, gasoline was not going to be free. As the stock market melts down, I intend to slowly get in to stock etf sectors that temporarily have an edge. This include stock etfs such as consumer staples, stable dividends, residential REITs, health care, telecommunications and utilities. As the market slowly recovers, I will gradually switch back to the broader market stock indexes in the US (including small caps) International and Emerging Markets. I know that no one can time the market exactly but I think that the broad trends for near future look fairly clear at this point. As of now cash is king but as Ray Dalio has pointed out, in the long run CASH is TRASH.
It all sounds so smart, but since when is a combination of bonds and gold called “barbelling”? And how exactly are you determining if a sector has an edge?
You say “as the market slowly recovers” but you seem to have missed the fact that it rebounded 25%+ in a single month.
You say you know no one can time the market but that’s exactly what you’re trying to do. Is this approach REALLY what you wrote down when you designed your long-term investing plan? I’m skeptical. I wish you the best of luck but I’ve seen a lot of people with a similar approach who end up buying high and selling low repeatedly as they invest based on their gut feelings. If you’re really as good at timing the market and identifying outperformers as you need to be in order to have this seemingly haphazard approach pay off, you should be managing a lot more money than your own.
Thanks for wishing me luck. Once upon a time I was in the buy and hold crowd in my 30s, 40s and early 50s but I cannot invest that way in my 60s. I believe that everyone times the market in one way or another. I believe that it better to try to understand the market, the best you can, rather than having a blind faith in 80-90% stocks. I agree that timing the market is difficult. I would suggest that you read articles from some of the research analysts I listed above rather than listening to the cheerleaders on CNBC. I think that this is something you learn after living through multiple market cycles. Gary Shilling, who is currently 83 years old, made the call of a lifetime when he invested in long-term bonds and held on to them starting in the early 80s. That one move guaranteed him 20% returns for greater than 30 years. His advice today is still cogent. Good luck if you believe that a 25% bounce in the market in the midst of a probable 20% unemployment rate and a severe recession justifies P/E ratios in nosebleed territory. More than likely this represents a bear market rally and not a new bull market. Interest rates are most certainly going to remain low (0 bound) for the foreseeable future and the Fed will make sure of that. Thirty year treasuries (with stops) will probably do OK for now in this environment. What comes after that is anybody’s guess. Gold does fairly well in both a recession and with inflation. I suppose a buy and hold strategy would be OK with a long investment horizon but I unfortunately do not have that luxury. You fortunately have a good business to fallback on but not everybody is in that same position. I think that the FIRE community might be a little anxious at this time. My advice for most people is to not give up their day job.
I agree that 80-90% stocks is probably inappropriate for you in your 60s.
I certainly don’t watch CNBC. Nor do I really listen to
gurus“research analysts” since the studies have shown their predictions are accurate less than 50% of the time.Long term bonds haven’t returned 20% for more than 30 years. That’s simply not accurate. That’s easy to see by looking at the lifetime returns on Vanguard’s long term bond index fund. The ETF was started in 2007 and has lifetime returns of under 8%. Even a bond bought in 1982 and held for 30 years only had a return of 14-15%.
I have no idea if this last rally is a bear market rally or a new bull market. The fun thing about my investing strategy is I don’t have to know. I’m not going to sell whether it goes down 25% or up 25% from here. On the other hand, for you to be successful with your strategy you do have to know.
Are you terminally ill or something? Why do you think your time horizon is so short? You’re only 60 something. You likely have 20-30 more years of investing ahead of you, and that doesn’t include money you are investing for your heirs.
I don’t mean to be critical, but your strategy sounds very emotionally driven, which is generally not a pathway to investing success.
No, as far as I know, I don’t have a terminal disease but thank you for asking. In fact I will be 64 yo this year and still working part time at the SLC VA. I’m not writing you to hurl insults at you but rather to give you a different perspective about the market. I happen to like your website and have been viewing it since it’s early beginning. If it had been around when I first started investing, I could have avoided a lot of mistakes that I have made over the years. I agree that if you are working and have a 20-30 year horizon, keep on investing, especially if you are just starting out. In my opinion, late career physicians and early retirees should be more strategic and selective when buying equities. If I have to wait till 84 or 94 until my stock portfolio breaks even, I will be short of cash during my go-go years. Remember Bill Bernstein once famously said: “ If you won the game, stop playing.” He also said stocks are risky and can be nuclear-level toxic in retirement. Remember that in the de-accumulation phase, I will be spending, leaving me vulnerable to sequence of return risk. Currently stocks are very pricey given the present circumstances. I felt that the market was going to correct this year even before Covid-19. The federal government is borrowing trillions of dollars on top of a baseline of 23 trillion. The federal reserve is printing massive amount of dollars and expanding their balance sheet. I understand that more spending is necessary to prevent a depression but do you actually believe that any of this debt is going to be paid. Despite this, the stock market continues to go up. Is this due to market fundamentals or emotion (animal spirits). We already know that energy producers, automobile companies, airlines, hotels, movie theaters, restaurants and other discretionary services will take a hit until we get a vaccine. I would think that most people would begin to save more at this point. If the federal government is able to prop up the stock market by spending more and more, I believe that this will lead to a bad outcome down the line. I think that it would actually be healthier for the markets to correct and let the scars heal. It would certainly benefit younger investors. Even the eternal optimist Warren Buffett said at his annual shareholder meeting that there may be unintended consequences down the line. He sold his airline stocks, is hoarding cash and hasn’t made any significant investments over the past couple of months. By the way, you can look up articles from Gary Shilling in Forbes. If you invested a 25 year zero-coupon treasury bond in October 1981 and rolled it over annually by November 2009 you would have had an annual return of 20.1%. If you had invested in the S&P 500 index at it’s low in July 1982 by November 2009 your annual return, including reinvested dividends, would be 11.8%. Long-term Treasurys outperformed the S&P 500 index by 8.1 times.
I’m also not trying to hurl insults. I’m trying to help. But I really don’t think market timing works any better at 64 than at 44. If you should have less in stock, you should have had less in stock a few months ago and not making these changes based on the market going down.
I also agree you need a plan for sequence of returns risk. I just don’t think market timing is the best plan to deal with that.
Dg135’s post is more sound than the WCI article. Preach on, boomer bro! Some of us are listening.
Every bear market feels different, but in a broad sense it never is. “This time is different are the four most dangerous words in investing”. John Templeton. Don’t listen to those who can spin a convincing story. Stick with the evidence.
On May 5, 2020, at 4:35 p.m., DG135 says “Long-term Treasurys outperformed the S&P 500 index by 8.1 times.”
Wow. 8.1 times. !!! Is that true, and please, what is the source.
Many thanks.
On May 5, 2020, at 4:35 p.m., DG135 says “Long-term Treasurys outperformed the S&P 500 index by 8.1 times.”
Wow. 8.1 times. !!! Is that true, and please, what is the source.
Many thanks.
Great article, no question. Love it.
Why are you asking me?
But no, it isn’t true for any significant period of time, much less the one he cited. But if you bought a LT treasury in 1982, you certainly had excellent performance. Interest rates back then were very high.
I have been a small value tilter since the mid-90’s, before they even called it “tilting” and have been unwinding my tilt over the last few years. I think the basis of my SCV position was/is that I view the small value tilt as a tool, rather than dogma or religion. The purpose of the tool from my perspective is to outperform the total stock market and, if you are inclined, to reduce your portfolio volatility by decreasing the equity allocation (aka Larry Portfolio).
If the tool is no longer serving my purpose, I do not know why I should keep using it. Since I have not realized the benefit in 25 years, what makes me believe that I will in the next 25 years, especially if I no longer need to outperform and can settle for boring market returns, going forward?
If I were starting my portfolio today, I am not sure that I would incorporate SCV. This may be an example where ignorance (not being aware of the academic underpinnings for SCV) is bliss and simplicity reigns.
That sounded like a very sophisticated sounding “I’m bailing out on SCV because I don’t like the tracking error” mixed in with a little “I don’t need to beat the market anyway to reach my goals.”
I guess that is correct. 25 years of waiting for the benefit of SCV is enough for me. I will save my allocation of patience for my marriage. 😉
I don’t think it’s been 25 years. My recollection is small value was outperforming right up until 2008 or so. But 12 or 15 years is a long time too.
Here you go:
https://www.whitecoatinvestor.com/periodic-table-of-investment-returns/
So small value outperformed large growth in 2000, 2001, 2002, 2003, 2004, 2005, and 2006. Small outperformed large in 2008, 2009, 2010, 2012, 2013, 2016 too.
Of course there were many years that SCV beat the overall market, but cumulative returns are more important, since we do not invest for calendar one year periods. We invest for a generation at least or for a lifetime. Small cap value outperformed the overall market in the first half of the 00’s (2000-2005 or so), the so-called “lost decade”.
It is hard for me to get 25 year returns on the small cap value index. The best I can do is the Russell 3000 (as a proxy for the TSM) and the Russell 2000 value index (as a proxy for SCV):
Periods ending: May 4, 2020
Index name 05/01/1995 through 05/04/2020
Russell 3000® Index 9.13% annualized return
Russell 2000® Value Index 8.24 annualized return
(from: https://indexcalculator.ftserussell.com/ICStep4DR.aspx)
Using those proxies, it appears that small has not outperformed large over the last 25 years. I don’t think the time is quite so long for small cap value, but it is certainly a decade plus.
Okay, now I am going to argue with myself. If there is has been 25 years of underperformance, perhaps it sets us up for reversion to the mean and outperformance for the next long period of time. Additionally, if you regularly rebalanced over the last 25 years, you probably more than made up for the underperformance in SCV.
For example, look at 1998 on the Callan table in your article. S&P 500 up 28% and SCV down 6%. 1999 S&P 500 up 21% and SCV down 1%. If you rebalanced on 1/1/1999 and 1/1/2000, you caught the huge SCV tailwind into the early 00’s.
Anyways, interesting mental and academic exercises. The easiest thing for non-investment geeks to do is to accept the market return, which has been good enough and behaviorally easier to stick to than tilting.
I agree it’s easier to do total market funds. I’ve always had somewhat mixed feelings about it. But one thing I have learned is that I’ve never regretted sticking with my plan. I’m far more likely to screw things up when I make changes to my plan. So I try to make them rarely and only with much thought and even a waiting period before implementation.
Hi, I have tilted to SCV with my portfolio due to the above rationale. But now I am thinking that momentum (possibly combined with value) is a more robust factor? Here is one source.
https://www.cxoadvisory.com/what-investing-approaches-work-best/
Also, some of the quant guys seem to think Size is not a factor (https://www.aqr.com/Insights/Research/Journal-Article/Fact-Fiction-and-the-Size-Effect).
Will be interested in what you and everyone else think about this?
I think size has always been considered one of the least significant factors. There is some good data on momentum out there. But switching from small value to momentum now feels like performance chasing to me. How do you know the pendulum isn’t about to swing back from momentum to small value?
I agree,
it sounds like its the Value premium that is lifting the SCV. I wouldn’t consider switching but adding to my portfolio- I like your IPS idea of waiting 3 months before making any changes. Its a matter of looking at the evidence and having a “good guess”
My 401K is quite limited. The only small cap options are WGROX and GOGFX.
I am leaning towards WGROX in part because of the lower expense ratio (1.19% for WGROX vs. 1.44% for GOGFX — both of which are still high relative to an index fund!).
As I was reading about WGROX it was described as being a small cap growth stock as opposed to a small cap value stock. Given my limited small cap options, should I just go ahead and add WGROX to my portfolio anyway?
Your article did a great job at explaining the potential benefits of small cap value stocks, but I didn’t get a sense as to how they compared to small cap growth stocks. Also, it wasn’t clear to me if you were suggesting in your article that individuals consider incorporating small cap stocks to their portfolios or you specifically small cap value stocks.
The other option I am considering is just forgoing small cap in my 401K altogether and instead adding a small cap value index fund to my taxable account.
Thoughts?
Both of those two options are actively managed and should be avoided. GOGFX is more value-leaning than WGROX, but even it does not have a strong value tilt. If you want a small value tilt, you should use your backdoor RothI RA or taxable account.
I agree. At 1% plus ERs, I’d try to avoid holding that asset class in that account if I can avoid it. Sometimes you can’t, but usually you can.
https://www.whitecoatinvestor.com/what-to-do-with-a-crummy-401k/
This article reminds me of the Callan Periodic Table of Investment Returns….Although I don’t think it separates out Small Cap Value, the overall gist is still the same.
Although I agree with the history of Small cap Value, it has taken a beating for the past 10 years…and with the larger cap monopolies (see FAANG) taking over it is tough to foresee Small Cap Value doing well again anytime soon. But reversion to the mean would suggest otherwise.
I will quote WCI with this one….”How clear is your crystal ball?”. 😉
It used to. See this post:
https://www.whitecoatinvestor.com/periodic-table-of-investment-returns/
Hi Jim, do you think that small cap value might be measured differently these days and this may be a reason why it is underperforming? It seems that defining value is quite difficult and given how companies operate differently across time there might be a difference between what value means in today’s companies versus value in the past? Also isn’t there a sector bias when you consider small value companies from the past versus small cap companies of today? Have these variables been controlled for when predicting that small cap value will still have a premium moving into the future?
Also what would you recommend as a drawdown/derisking strategy when your in retirement for the small-cap value asset class? Should you time the market where you would not draw down/bond convert your small cap value asset class if it is not doing well compared to other equity asset classes? Should you draw down/convert to bonds only when it is out performing other equity asset classes? Or should it be the first of your equities to draw down given you cannot predict when the premium will show up in retirement and given that it’s a risky Asset class it should be the first to go?
I’m not aware that the measuring sticks of today are dramatically different from those of yesteryear.
I cannot guarantee there will be a small cap premium in the future, but assuming it was real in the past and not just artifactual, I don’t see why anything has changed.
I plan to draw down my portfolio equally, thus most of the withdrawal will come from whatever has done best in the last year- bonds, REITs, TSM, small value, whatever.
I’ve been tilted towards small cap value and international for a while, especially given the long decade plus of underperformance.
As a former bank lender, my only hesitation on small cap value is wondering if the companies are even public anymore after Sarbanes Oxley. A steady, cash flowing small cap business can be taken private, eliminate all the compliance cost of being held as a public company, and make a nice little holding for an insurance company, family office, or lower risk private equity fund. I saw numerous businesses in my career that would be a nice small cap public company, but the millions of dollars to comply with being public created too much of a drag and the business made other choices to have liquidity and transition ownership.
I’m still betting on small caps long term, but that is the case against them.
Do you have any theories as to why small value has “underperformed” in the last decade? I would hypothesize the small value is intricately linked to the concentration of wealth in the US economy. The greater the distribution of wealth, the better I’d expect small value to do—and vice versa. What do you think?
It’s normal . All factors, including market beta (total market) can have long periods of under performance. Small cap value has had 3 periods of 13 years under performance since 1926. That’s what can make it difficult to stay the course. When these periods of under performance will occur is unpredictable, which is the idea behind diversifying across factors. Maybe the next decade small cap value will out perform the broad market.
I’d actually bet on it. Come to think of it, I have. Our entire 401(k) contributions for the year went in to SV last week to help rebalance! But there’s obviously no guarantee. LG could continue to outperform for another 10 years, but it seems less likely to me.
Doubt that has much to do with it. SV and LG seem to swing back and forth. The last decade it has been LG’s turn. Maybe the next will be SV’s turn. A lot of it comes down to sectors too. LG tends to be value and tech and that’s what has done well recently. SV is mostly other sectors.
Dr. Dahle,
Putting a lot of thought into transitioning away from my Large Cap Growth tilt and to Small Cap tilt. Really enjoyed your podcasts w/ Merriman and Ferri.
My question is, in order to tilt small, do I really need to tilt to Small Value or could I just tilt by putting a percentage into a Small Cap Index that is more of a Small Cap Blend approach and get the same desired effect.
I invest with Fidelity…their Small Cap Index (FSSNX) has a slightly lower ER and overall better historic performance than Small Cap Value index (FISVX). *Granted, FISVX is still a pretty young fund*
Your thoughts? I’m probably splitting hairs with the ER analysis and perhaps I’m just being reluctant to go full SCV tilt.
You can just tilt small. Be aware that historically the value premium is larger than the small premium though.
Bear in mind when looking at historic performance that recent underperformance of value is going to make value look worse than the long term historical data indicates.
Fair enough, thanks for the reply!
It’s almost like the green and red percentages on these websites are triggering an emotional response!
First off, I wanted to say how much I’ve enjoyed the website, thank you for the great resource.
I definitely suffer from analysis paralysis (I enjoyed your most recent article on that…) and I hired a financial advisor who developed an IPS for me with an asset allocation of Large Cap Growth 17.5%, Large Cap Value 17.5%, Small Cap Growth 17.5, Small Cap Value 17.5%, Large Diversified International 10%, Emerging Markets 10%, Real Estate 10%.
I was all ready to start investing according to this plan, but then I went ahead and read Bernstein’s Book on Asset Allocation where he does NOT recommend using SCG. Now I don’t know what to do… I have read on your website and elsewhere that the most important decision for passive investing is asset allocation and now I am paralyzed by trying to optimize the asset allocation. Bernstein seemed pretty clear he didn’t like SCG therefore, should I revise the IPS to get rid of SCG,? just double the amount of SCV and not do SCG? I invest at Fidelity and they charge fee’s for buying Vanguards funds, but not their ETF’s (or any other companies Funds)
Thanks!
Ha ha. Welcome to the club. Nobody knows the right asset allocation. Pick something reasonable and stick with it, not being swayed every time you read a new article advocating something a little different. But most people it takes a year or two to really settle in to what you can stick with for decades.
Personally, I don’t like SCG and see little reason to have a portfolio split 50/50 growth and value. If you’re going to do that, just use a blend fund like Total Stock Market. The only reason to split it out is to have some sort of tilt (typically a value tilt) where you might have 20% large blend and 15% large value etc.
This article has aged well.
I have tilted to SCV and Emerging Markets since 2014 after reading Bernstein, Ferri, and Swedroe’s work at the beginning of my professional career. Looking back, a key driver to staying the course after understanding the research you eloquently summarized above is to set yourself up for success behaviorally. I hold only SCV and Emerging Markets in my Roth IRA to execute my tilt, and re-balance them off one another. Once yearly contributions create a systematic process for buying and re-balancing, and seeing their performance only against one another (vs. Total US Market or S&P500) helps to avoid any rash decisions based on tracking error.
I “doubled down” on my SCV tilt in April 2020 after understanding more about the valuation spread against Large Cap stocks driving the total market returns, and observing my own behavior during the Covid crash. As of today, the decision to increase SCV allocation and decrease Total US Market has paid off handsomely, with SCV stocks seeming to gain momentum in the near term as our country exits the pandemic.
Our multi-year opportunity to buy SCV “on sale” could be nearing a sad end.
I don’t know if SCV or TSM is going to outperform over the next 1, 5, or 10 years, but I’m confident enough that my tilt will pay off over my investment career to maintain it.
If I had to make a big bet, I’d certainly bet that SCV is going to outperform TSM over the next 10 years, but my crystal ball is cloudy so I’m glad I don’t have to make that bet.
A lot of talk about nominal returns, some mention of risk, but no discussion of risk adjusted returns.
A comparison of Vanguard Total Stock Market to Vanguard small cap value over the entire period they both existed shows the SCV doing better on a nominal basis, a higher SD than TSM, a small outperformance on Sharpe ratio but less favorable skewness and kurtosis metrics. Overall, these two funds are different but it would be hard to say one is better pretax. I have not checked what the tax implications would be in a taxable account. Vanguard does pretty well with taxes, so maybe there is not much difference.
Of course, if held in a tax favored account, this would not matter.
Can we talk about risk adjusted returns? Are they any better for SCV or other factors? There are plenty of papers that say they are not. Not to appeal to authority but merely to cite who said it, even a factor pioneer like Fama does not say that the factors he studies produce higher risk adjusted returns.
If I cannot get higher risk adjusted returns, then why bother with tilting? I can dial in my desired risk with my percent stocks and bond duration. No need for higher cost funds at all.
Factor tilting doesn’t give you higher risk adjusted returns. It gives you higher expected returns, but with higher risk. There is no free lunch. What it does give you is a higher expected return, and it also increases the reliability of the investment outcome, by adding multiple sources of expected return (size, value etc.). In others words there is a diversification benefit because these factors (including market beta – total market) often do well at different times. Eg. from 2000 to 2002, the total market dropped 50%, but small cap value went up significantly. By diversifying across factors you are not relying on just one source of return in the market.
I suppose it comes down to whether you believe historical small cap value performance not only will continue, but whether it is due to risk or due to behavior. If due to behavior, it would have higher risk adjusted returns. If due to risk, it may not and it’s a diversification play. The truth is probably somewhere in the middle. Or it’s all just data mining–also a possibility.
Jim, great article, good discussion.
One thing I don’t understand: what is the point of having small cap value tilt when you could just have Total Stock Market fund and simply decrease holding in bonds? To me it only makes sense to have small cap value tilt if you are 100% stock 0% bonds because you are then attempting to realize higher returns on your portfolio. Can you comment on this?
Thanks for all you do.
A factor investor considers market, small, and value to all be separate risks with risk premiums. By increasing stock to bond ratio, you’re simply loading up on market. By adding small value, you’re diversifying into all three factors.
WCI,
Just took over my own personal investing after being in DFA funds. My plan is pretty close to your current portfolio but I decided to do a much smaller Real Estate portion (5%) and with 20% bonds.
My US Small Cap Value and International Small Cap Value is currently underweighted (mostly in my taxable account which is about 2/3 of my investable assets at this point).
Would you recommend overweighting new positions in those underweight areas (maybe 2:1 Small Cap Value: Total stock market) or just keep plugging all that into small cap value until meeting target allocation?
Thanks.
What do you mean when you say you’re currently underweighted? Compared to what? Market weighting doesn’t have any specific small cap fund.
To be more precise I mean that my dollars invested in both US Small Cap Value and International Small Cap Value are below their target allocation.
I was able to balance my to my target allocation in my retirement accounts much more easily. (This is only about 1/3 – 1/4 of my total assets)
However, in all my accounts I am about 6% under allocated to US Small Cap Value and about 3% under allocated to International Small Cap.
I am trying to decide between:
1) Invest higher ratios of new money into the asset that is below target allocation (ie 2:1 or 3:1 of small cap value:total stock market) — it is going to be more than $100K to get up to target
or
2) Only invest in the asset that is below target allocation (ie 100% small cap value).
Thanks.
I put it all into the below target allocation asset class. Then I do the same thing next month. Remember percentages don’t have to be perfectly balanced at all times. Just close enough.
WCI,
Do you favor ETFs for small cap value (you mentioned VBR)? My Fidelity Small Cap Value Index Fund (FISVX) just had a Long term Capital gain distribution, Short Term Capital gain distribution, and a dividend —- Looks like this will occur again in December.
VBR has a Distribution Yield (TTM) of 1.63%
Just trying to compare apples to apples….How do you recommend looking at that to minimize taxable events?
I could probably convert some to VBR if this is clearly the winner.
Thanks again .
Mutual funds or ETFs are both fine. I’ve used both and am currently using both for SCV. More info here:
https://www.whitecoatinvestor.com/mutual-funds-versus-etfs/
Thanks for the article! Do you use VSIAX or VBR for your Vanguard small value fund? VSIAX has had slightly higher return 2.84x where it started in fall 2011 v. 2.73x where VBR started in fall 2011. Same expense ratio. Any reason you would pick a technical ETF over a technical mutual fund?
It’s the same fund. Returns shouldn’t be any higher if you compare apples to apples. When I look at Morningstar, the 10 year returns are 11.59% for the ETF versus 11.58% for the fund. Same, same.
Buy the one that makes sense for the account you are using. For example, if you’re using a 401(k) at Schwab, you would use the ETF version for the lower fees.
https://www.whitecoatinvestor.com/mutual-funds-versus-etfs/
So strange .. when I plugged into google finance for the exact same dates, it gave me different returns (as mentioned in original post) but when I went to Vanguard’s website I get the same returns. Might be something funky with google finance’s reporting. Thanks for the reply!
To my understanding, the returns reported in Google finance or Yahoo finance do not include reinvested dividends. The reported returns only reflect the funds’ trading price. For a good site to compare funds with reinvested dividends, I’d recommend using portfoliovisualizer.com
With nearly 17 years of factor titling under my belt, it’s just not worth it, as the results were average to sub-par. Given an investment horizon of at best of 50 years to retirement that represents nearly 33% of an investment period and to wait a few more years till it paid off (if it does) seems like a huge gamble. I don’t think it’s worth it. I think one would be better off in a 60/40 Total US / Total Bond or if needed 48 Total US / 12 Total International / 40 Total Bond (set it and forget it), but make sure the International includes Emerging Markets else those returns will be sub-par. Perhaps I chose the wrong 17 years to be in it, perhaps it really worked great in the past and not so great now.
If you were only prepared to hold on for 17 years, you probably shouldn’t have tilted in the first place. Could take decades to pay off. Of course, it’s entirely possible to never pay off.
In his Telltale speech (https://johncbogle.com/speeches/JCB_Morningstar_6-02.pdf) Bogle talks about the Six Manifestation of RTM (Reversion to Mean)
1. RTM – Large-Cap vs. Small Cap
2. RTM – Value Stocks vs. Growth
3. RTM – in the Market Portfolio
4. RTM – in Equity Mutual Funds
5. RTM – and “Slice and Dice”
6. RTM – and the Stock Market
It’s worth the read since these are in essence the factors that people discuss today and Bogle uses “telltale” charts to explain them away, but he does mention Pascal’s wager and uses it as an example for the marketplace:
In a temporal sense, the all-market portfolio is consistent with the spiritual argument about the existence of God put forth by Pascal three centuries ago. If you bet God is, you live a moral life at puny cost of giving up a few temptations. But that’s all you lose. If you bet God is not and give in to all your temptations, you’re forever dammed. Consequences, Pascal concluded, must outweigh possibilities.
Similarly in the stock market, if you bet the market is efficient and hold the market portfolio, you’ll earn the market’s return. But if you bet against it and are wrong, the consequences could be painful. Why would you run the risk of losing, perhaps badly, when the market return, earned by so few over the long-run, is there for the taking?
He concludes the message of the telltale chart is universal. Unlike the regular, louder, ever more distinct pulsations of the telltale heart in Poe’s frightening story, however, reversion-to-the-mean in the financial markets is irregular and unpredictable—sometimes fast and sometimes slow, sometimes distinct and sometimes almost invisible. Just when we despair of its universality it strikes again. And so there is always hope—today, for those who await the almost inevitable recovery in stock prices. But I remind you that while we may know what will happen, we never know when. So rather than relying on hope—never a particularly good idea in the stock market—rely on an asset allocation that focuses not only on the probability of reward, but the consequences of risk
In my case, I used what Jack Bogle would describe as “play money” (a portion of my portfolio. I tried the factor tilts (small vale, large value, International small value, International large value). In 17 years all four were absent. If this was all of my money I would have seriously shot myself in the foot.
I wish I had read Jack Bogle’s Telltale speech first as I probably would have never embarked on this experiment. You’re right about one thing, maybe 17 years was too little time. I was willing to let it ride for the rest of my investment horizon, but what if took 34 or 51 years and it was still absent? People need to ask themselves how much returns they are willing to give up in the hope that something which appeared/disappeared in the past will appear/disappear in the future? Is it worth the risk?
I concluded for me that it was not, but perhaps others will do better, Bogle was right and I don’t give him enough credit, he knew far more about investing than many people.
Yup, one should not tilt more than one believes.
The other thing I figured, at least in the long term, is why should SV underperform? If it’s all truly RTM, SV should do about as well as the overall market in the long run.
Over the last 15 years VBR has returned 7.2%. VTI has returned 8.2%. That’s not enough underperformance to destroy a plan, even if one is heavily tilted.
It’s also not enough of a reason to embark on such a journey given that more risk is needed for at best the same return. I think that is what Jack was trying to say in his Telltale Speech. If you step back, do you still see the slide?
Not sure what you’re talking about with the slide.
The slide was a reference to The Telltale Speech which Jack Bogle gave in 2002:
In any event, place me squarely in the camp of the contrarians who don’t accept the inherent superiority of value strategies over growth strategies. I’ve been excoriated for my views, but I’m comforted by this reported exchange between Dr. Fama and a participant at a recent investment conference: “What do you say to otherwise intelligent people like Jack Bogle who examine this same data and conclude that there is no size or value premium?” His response: “How far are they from the slide? If I get far enough away, I don’t see it either . . . Whether you decide to tilt towards value depends on whether you are willing to bear the associated risk . . . The market portfolio is always efficient . . . For most people, the market portfolio is the most sensible decision.” Amen!
The pendulum swings. For the last decade, large, growth, and US have been the winners. It will swing back. What the long term results will be is to be determined.
With over 40 years of years of investing, my observation is that Small Caps generally break-out first after a recession as many are part of the supply-chain for the Big Caps. You’ll probably get your wish once the recession is over and the recovery begins. Good luck