When it pays to go all-in on small-cap value
Reprinted courtesy of MarketWatch.com.
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My recent articles on performance generated considerable reader feedback, with lots of people wanting help with applying the facts to their portfolios.
Below, I’ll answer four questions that came up.
Q: The long-term returns of the Standard & Poor’s 500 Index were so much lower than those of large-cap value stocks, small-cap stocksand small-cap value stocks, that I wonder: Is it reasonable to build a portfolio without including the S&P 500 at all?
A: Over 87 years, the average return for all four asset classes was 11.7%. If you eliminate the S&P 500 index , the return was 12.3%.
That is compelling, since even an extra one-half percentage point in long-term return can add millions to your lifetime gains.
But there’s a downside. Such a strategy would eliminate the asset class that has held up best during major market declines, and it would leave you with two-thirds of your equities in small-cap companies.
Investing is easy when everything is going your way. But every investor has a breaking point. When your portfolio is seriously out of sync with “the market,” it won’t feel comfortable.
From 1980 through 1999, the S&P 500 compounded at 17.9%, while the other three averaged 17.6%. This might seem like a trivial difference, but the other three also gave investors a much rougher ride, with 40% higher standard deviation.
If I were going to eliminate large-cap blend stocks (the S&P 500) from an equity portfolio, I think I’d also eliminate small-cap blend stocks. That would give me a portfolio of large-cap value and small-cap value.
The long-term average of these two asset classes was 12.4%, so eliminating small-cap blend doesn’t sacrifice performance.
Q: I am under 30 and considering putting my 401(k) entirely into a small-cap value index fund. What do you think?
A: Even though I don’t want to give you specific advice without knowing more about your circumstances, I can tell you I’ve come to believe that overweighting to small-cap value stocks can be a great option in the early years of saving for retirement.
For somebody who can tolerate the risks, I think it makes sense to be all-equity until age 35 to 45. And for the first 10 to 15 years of your investments, I think an all-value portfolio (including large-cap and small-cap) is worth considering.
Here’s an alternate suggestion: If you have 40 or more years to go before retirement, consider making a major lifetime commitment to small-cap value. (This can include international small-cap value funds in both developing and emerging markets).
Specifically, think about investing $5,000 a year into small-cap value funds for 40 years. In the early years that may be all you have to invest. When you can invest more than that, put the excess into other asset classes. This will gradually diversify your portfolio into one with a lower risk profile.
If you invest $5,000 a year for 40 years, that is $200,000 out of your pocket. If that money compounds at 12% (in the ballpark of the historical record for 40-year periods in small-cap value stocks), you could have almost $3.8 million at retirement.
If you then withdrew 5% a year, you would have about $190,000 (nearly as much as all the dollars you invested) to spend in just one year. If the portfolio continued to grow, that annual withdrawal would grow as well.
Let’s imagine you continued making those 5% withdrawals and you lived for another 25 years. If your account earned just 8% during your retirement, you could wind up with an estate in the neighborhood of $8 million to go to your favorite people and your favorite causes.
All that is banking heavily on a bunch of assumptions. But it shows what is possible without stretching the limits of the record of the past 87 years.
(And all that results from only the $5,000 a year you invested in small-cap value stocks, not counting other investments or matching funds from your employer.)
Q: How real are your numbers? Small-cap value is a risky asset class. How many of those companies survived? Does the study take bankruptcies into consideration or is there a problem with survivorship bias? And finally, now that everybody knows about the advantage of small-cap value, how likely is it to repeat?
A: Those are very good questions. For past performance, the numbers are totally real. But of course the future is still completely unknown.
These performance figures take into consideration all the companies that bit the dust. That means the phenomenon of survivorship bias is accounted for.
Your last question implies that small-cap value’s long-term record has been a secret until now. But it hasn’t.People who have paid attention have known about this performance for many decades. And yet investors haven’t been flocking to take the risks involved in buying companies that are both relatively small and relatively out of favor.
I suspect that, partly for that very reason, the relative value of small-cap value will remain.
But for fun, suppose that suddenly millions of investors started buying the stocks in your small-cap value portfolio.
That would drive the prices of those stocks up, pushing some of them into growth-stock territory, but not before giving you some great profits.
Q: Vanguard will let me mix mutual funds with ETFs. Since you have pointed out thatVanguard Small-Cap Value Fund is not really a small-cap value fund, what about using a Vanguard small-cap value ETF that might do a better job of representing the asset class?
A: In my Vanguard ETF Portfolio I recommend the Vanguard Russell 2000 Value Index VTWV, +1.09% I recommend iShares S&P Small-Cap 600 Value ETF IJS, +0.85% in my Fidelity ETF Portfolio and SPDR S&P 600 Small Cap Value ETF SLYV, +0.42% inmy Schwab Portfolio. SLYV has the lowest expense ratio. They have very similar asset class exposure and each one of them is more oriented to small-cap stocks and value stocks than the Vanguard Small Cap Value Fund VISVX, +0.43%
Richard Buck contributed to this article.