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Overweighting Small-Cap and Value Stocks

If you take a look at the Lazy ETF Portfolios post from a while back, you’ll notice that many of the portfolios’ creators make it a point to overweight small-cap stocks and/or value stocks. Why is that?

Generally, it’s for either (or both) of two reasons:

  1. To provide additional diversification.
  2. To increase expected return.

Additional Diversification

It seems odd to think that, when it comes to U.S. stock holdings, anything could be more diversified than a fund that simply tracks the entire market. Yet Larry Swedroe, in his What Wall Street Doesn’t Want You to Know makes exactly that case:

“The appeal of owning the entire market is intuitively attractive from a diversification perspective. However, the market-cap weighting mechanism that is used to make index funds easy to manage provides a far different outcome from what one would expect….Almost 70% of the portfolio is large-cap growth stocks.”

His natural conclusion, then, is that most investors would achieve better diversification by supplementing their large-cap growth holdings with funds that track small-cap and/or value indexes. In fact, if you take a look at his “Big Rocks Portfolio,” you’ll see that approximately 2/3 of the stock allocation is invested in either small-cap or value funds.

Improving Return

The second reason that many investors decide to tilt their portfolios toward small-cap stocks, value stocks, or both is that these stocks have historically earned greater returns than their large-cap and growth counterparts. This makes sense given their risk profiles:

  • Value stocks are presumably companies whose future prospects (as companies, not as investments) are rather dim compared to other companies.
  • Small companies clearly carry a higher level of risk than well established companies that are already leaders in their respective fields.

And given that they both carry higher risk, it’s only natural that the market would demand a degree of additional return, commonly known as a risk premium. (This is the same thing that goes on with stocks as compared to bonds–the expected return for stocks must be greater than the expected return for bonds in order to get people to own stocks.)

Makes Sense to Me…

I have to admit, however, that while this strategy makes sense to me, I have not implemented it in my own portfolio. I’m not entirely sure why. Perhaps there’s some part of the idea I’m not sold on. Or perhaps I just place a high value on the simplicity of my own portfolio.

What about you? Do you tilt your portfolio toward small-cap or value funds? If so, why? If not, why not?

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Comments

  1. I do. But the small cap premium (over large caps) is much larger than the value premium (over growth). If you’re going to do it, I’d focus on overweighting small caps first. Overweighting value is a small bonus.

    The problem Swedroe noted with a total market fund is key. You don’t get very much in small companies, and they’re the ones likely to make the most money.

  2. I don’t mind adding some small companies on occasion. Most of mine are done using index funds, though, based on small caps.

  3. I do too. I use modified FundAdvice.com Suggested Portfolio for Vanguard, which is also featured on Paul Farrell’s Lazy Portfolios. For my domestic equities, I have equal weighting for Large Cap, Large Cap Value, Small Cap, Small Cap Value and REITs. I realized that this increased my volatility and risks. I balanced it with increasing my fixed income portion, which is very conservative since I only use Short-Term Treasury, Intermediate Term Treasury and TIPS. I listed what I have in my portfolios in this post http://moneychronicle.blogspot.com/2009/08/managing-my-asset-allocation-between.html

    Talking about FundAdvice.com, I would suggest Sound Investing podcast (http://www.fundadvice.com/sound-investing/). Larry Swedroe is a regular guest on that podcast and he was the guest speaker on August 28 show.

  4. Mnartin Stern says:

    An alternative to adding small cap and value is to increase the proportion of the total market equity over fixed income in one’s portfolio. Increasing equity exposure also increases both the expected return and the risk. Not sure which is a better strategy for a given amount of risk

  5. Another way to capture the tilt that you talk about is to tilt toward smaller caps within the large cap allocation. For instance, using RSP, which is an equal weight S&P ETF.

    Small Value has been talked about a lot as the best for outperformance according the Fama/French crowd.

  6. Mnartin (Martin?) – Historically speaking, adding small companies and value companies is better than just increasing your stock allocation for a given level of risk. Just increasing your total stock allocation does nothing to diversify yourself between the large and small companies. You’ll still have mostly large companies if you’re using a total stock market fund.

  7. i do it, but i put it in perspective. your overall asset allocation (equity/fixed income) to me is a much bigger decision than small-value tilting. I even think the international vs. domestic allocation you choose matters more. you basically just squeaking out an extra bit of expected return by tilting. Which brings up another issue: how much “tilting” is too much? 10% small value? 20% small value?

  8. I don’t do it for the reasons JC raises. I don’t know how much to tilt. A little tilt won’t matter much. I’m not sure a big one makes sense. In the end, I find it easy and comfortable to cap weight. I understand it and I don’t have to think much about rebalancing.

  9. historicaly, at leaste when I looked at it in 2007, the value group of stocks outperformed the group over a 10 year period, a little outdated I know.

    As for my domestice section I do a 60/20/20 mix, 60 large 20 mid and 20 small cap. That is because if we look at the 8 year return of the large cap it sucked from 2000-2008, which I why people are calling this the lost decade. but by adding small and mid cap all of the sudden your return for domestic stocks increased to about 4-6 % instead <1.

  10. my time frame for the 8 year return of large cap is before the market decline.

  11. Value and small caps are expected to lead to greater returns because of the greater risk involved, just as you suggest. But investors tent to think of this increased risk as just being greater volatility (bigger ups and downs) and say things like, “I’m willing to ride it out for those greater returns.” But, that’s not really what the risk adds up to. The risk you actually take is the risk that tilting won’t ultimately result in any greater returns and may end up hurting your returns.

    Prices are set by a market. It’s the market that constantly seeks out fair value and, in doing so, prices uncertainty at a greater discount (thus creating the risk premium). And that same market does not want rewards to be disproportionately greater than risks either.

    Also, when considering to tilt, there is a chicken and the egg situation that differentiates the value premium from the size premium. Any size company becomes a value company when the market makes it such by collectively concluding that its fair value should be at a greater discount to its potential future value relative to other companies. In other words, the additional risks define the composition of group.

    With small cap companies, the composition of the group defines the additional risks. While capitalization is impacted by stock price, small caps are not defined by the market’s collective opinion of the each company’s risk like with value companies. Instead, the inherent risks associated with smaller capitalization companies demand a greater discount relative to larger companies companies. This difference creates a more distinct sub-market, “the small cap market,” than a “value market,” and in theory, should result in a more reliable risk premium.

  12. I just revised my asset allocation this past week. I had been putting it off for a long time. Initially, I had started my ROTH IRA’s with Vanguard, and used the Target Retirement 2045, since the account started out at the $3k min per fund. Fast-forward a few years, account has grown, and I decided to finally get my ROTH, wife’s ROTH, my ROLLOVER IRA, and both of our 401k’s to start working together. I think the multiple accounts was what kept me from doing this earlier… I was worried I couldn’t get them to work together as one portfolio.

    My favorite book on this topic is All About Asset Allocation by Rick Ferri (I’ve met him, too – cool guy), which I read years ago, but slacked off on implementing his advice. He does a good job explaining how different mixtures work together to (potentially) increase return while lowering risk… which is the intent of tilting towards small-cap value.

    I decided on the following:
    80/20 stock/bond mix
    30% of stock % as international
    25% of stock % as small value
    50/50 US bonds/tips

    Which breaks down to approximately the following:
    35% US total stock mkt index fund (VTSMX)
    20% US small cap value index fund (VISVX)
    25% international index fund (VFWIX)
    10% US bond index fund (VBMFX)
    10% TIPS fund (VIPSX)

    I’m using all Vanguard index funds (as noted above), except for a few Fidelity index funds in my 401k, and I had to approximate the total stock market using an S&P fund and an extended market fund in my wife’s 401k. But overall, I think it will work nice, and am glad I finally implemented it.

    cheers, my2fish (thad)

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