The long-term historical return on smaller and more value-oriented stocks has been impressive. The table below shows that from June 1927 to June 2019, while the S&P 500 compounded at +10% per year, small cap value stocks earned over 3% per year higher returns. $1 invested in the S&P 500 in 1927 grew to $6,615. That same dollar would have grown to $89,090 in small cap value stocks, a staggering difference.
On a monthly basis, the average return on small cap value stocks has been over 0.4% higher than the S&P 500 -- keep this in mind when you hear about index funds reducing their fees by 0.01% per year, or "robo-advisors" who offer to charge 0.4% per year lower fees.
Asset allocation matters far more than small differences in expenses.
The premium return above the market for holding smaller and more value-oriented stocks doesn't materialize in every period. Of course, the same can be said about the premium return expected for holding stocks over bonds.
Most investors and even many financial advisors don't understand this reality and their portfolios suffer in terms of inferior asset allocations (that don't target higher-expected returns) and ill-advised timing moves (that trade out of them at the wrong time). For a recent blog article that illustrates this point, click here. Shifting out of small cap value stocks and into Total Market Index Funds is one example that is especially common today amongst do-it-yourself investors and many financial advisors. This, like all market timing moves that have been popular in the past, will probably not end well.
In order to earn the premium associated with any expected return, whether it is small cap value stocks over the market or simply stocks over bonds, you have to be patient enough to be fully invested if and when the higher return materializes. This often happens after a stretch of disappointing returns. The last two weeks provides us an illustration of this principle.
Since August 27th, not only have stocks come back from a difficult stretch in July and early August, but small cap value stocks in particular have rebounded sharply. The S&P 500, represented in the Morningstar chart above by the Vanguard 500 Fund (VFINX), has gained +4.69% in just 11 trading days. Small cap value stocks, represented by the DFA US Small Value Fund (DFSVX), have done far better, earning +12.16%. That is only 1% less return than it's long-term annual average since 1927...in just two weeks!
But to earn this return, you had to rebalance your portfolio recently, most likely out of high-flying large cap growth stocks and into lagging small value companies. This is harder said than done, buying what is out of favor is naturally difficult for all investors who tend to instead follow the herd.
The other, less appreciated aspect of capturing a return premium is using an investment vehicle that is well designed to deliver the expected return. In the chart above, the Vanguard Small Cap Value Index (VISVX) is also linked. You would think the DFA and Vanguard funds would have similar results given their identical fund names. But significant differences can result from mutual funds and ETFs with similar objectives.
The Vanguard fund has earned only +8.83% over this stretch, over 3% less than the DFA fund. Why? It doesn't focus on the smallest or the most value-oriented stocks, and its portfolio is only "reconstituted" (updated) twice a year. The DFA fund holds smaller companies, lower-priced value shares, and the portfolio is managed on a daily basis using fund inflows, outflows, and dividend distributions. It therefore targets small cap value stocks more consistently. The result is a strategy far better designed and managed to capture the small cap value stock returns that long-term investors should care about.
Higher relative returns don't show up in every period, which can make achieving investment success a difficult task. But by staying disciplined and exercising patience, you are better positioned to capture investment returns wherever and whenever they materialize. Of course, this is overwhelmingly difficult for most investors to accomplish on their own. Hiring an independent, fee-only advisor who can design and manage a personalized plan for you on an ongoing basis while helping to keep you confident and disciplined could be another great investment.
Past performance is not a guarantee of future results. Index and mutual fund performance includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. This content is provided for informational purposes and should not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services.