Paul Merriman
Sound Investing For Every Stage of Life 

Performance Series- Q & A’s

The following 10 Q&A’s are specific to Paul’s series of “Performance“. The first four appear in hisMarketWatch article of March 25, 2015.

Is it reasonable to build a portfolio without including the S&P 500?

Q: The returns of the S&P 500 (read article) were so much lower than large cap value (read article), small cap (read article) and small cap value (read article), is it reasonable to build a portfolio without including the popular index?

A: The average return for the 4 asset classes was 11.7%, (read “4-Fund Combo Wallops the S&P 500″) but if you eliminate the less profitable S&P 500 the return jumps to 12.3%.  That’s the good news!  As you may remember in my article “A half of percent that can change your retirement,” an extra .5% can make the difference of millions of dollars over a lifetime.

The bad news is you will have eliminated the asset class that is likely to hold up best during major market declines, plus you will have 2/3’s of your equities in small cap companies. Every investor has a breaking point and I suspect there will be times it feels terribly out of sync without at least a part of the portfolio in the large cap blend camp. For example, from 1980 through 1999 the S&P 500 compounded at 17.9%, while the the other three averaged 17.6%. This might seem like a small difference but it’s important to note that the volatility (standard deviation) of the other three is about 40% higher.

If one wanted to eliminate the S&P 500, I would probably be more comfortable with a portfolio of a large cap value and small cap value funds or ETFs. Most of the top 25 companies in the Vanguard Value Index are the same of the top 25 in the S&P 500.  While the 50% of the portfolio in large cap companies are not the cream of the crop, they are large established companies who are likely not in the hottest industries or stumbling due to industry specific challenges, like the severe sell off in oil prices. For example, the S&P 500 has about 8% in energy stocks, while the Vanguard Value Index has 11%. 

Should I put all of my 401k into a small cap value index fund?

Q: I am under 30 and considering putting all of my 401k into a small cap value index fund. With almost 40 years ahead of me doesn’t it make sense to be all equities and have that all be in small cap value?

A: I don’t know all the particulars about your financial situation: How much you are saving, your risk tolerance, what your spouse might be doing in their retirement account, etc.? But based on my conversations with most young investors, I think it is a great idea to overweight to small cap value in the early years of investing for retirement. I am an advocate of putting all of the retirement investments into equities until age 35 to 45, depending on risk tolerance. And for the first 10 to 15 years I think an all value portfolio (including all small cap value) is okay.

But I have another approach for you to consider. If you have 40 years ahead of you, I would like you to consider a major lifetime commitment to small cap value. When you are done with my entire performance series you may decide to expand your small cap value to include some international developed markets and emerging markets small cap value.

Rather than suggesting you put all of your money into small cap value, I would like you to consider putting $5000 a year into small cap value over the next 40 years. In the early years that might be all you can invest but, as you make more and save more (including the company match to your 401(k), you can expand your exposure to other asset classes.

Let’s assume you maintain the commitment to investing $5000 to small cap value over the 40 working years. Let’s also assume you can make the investment into a Roth IRA or Roth 401(k). Your total investment will be $200,000. As I’m sure you noticed, the U.S. small cap value index 40-year average compound rate of return was 13.7%. The best 40 was 15.9% and the worst was 10.7. (See the “Four Fund Solution Table” for the 4 asset classes and 4-fund outcome).

For purposes of guessing what could happen, lets assume a 12% CRR. At the end of 40 years this part of your portfolio (and I’m assuming over 40 years you, and your company will have invested at least several times the $200,000) could have grown to almost $3.8 million. If you tap into this bucket for a 5% a year distribution, each year’s distribution will almost equal the amount you invested over the 40 years. Plus, if you take out 5% a year and it grows at 8%, your children and charities will have $8 million to divvy up at the end of 25 years of retirement. 

How real are your numbers? 

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: The results of the Fama/French studies of small cap and small cap value asset classes are adjusted for bankruptcies, mergers and delisting. If they hadn’t adjusted for these common risks of smaller companies, their peers would have roasted their work as meaningless. Peer review is one of the advantages of academic research.

There is no way to know whether the past will repeat. With many more investors understanding the small cap premium, it is likely the premium will be smaller. The period 1970 through 2000 produced large cap blend returns that were about the same as small cap blend, so it is normal to have long periods of similar returns. The expectation is the extra return will be between 2 to 5 percent a year. During the last 40 years the spread has been 5 to 7 percent. (For more on this subject, listen to my podcast,

Should I use ETFs instead of Vanguard’s Small Cap Value Fund?

Q: Vanguard will let me mix mutual funds with ETFs. Since you have pointed out that Vanguard Small Cap Value Fund (listen to podcast, “What’s Wrong With Vanguard Small Cap 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 (WTWV). I recommend iShares S&P SmCp 600 Value ETF (IJS) in my Fidelity ETF Portfolio and SPDR S&P 600 S-C Value ETF (SLYV) in my Schwab Portfolio. SLYV has the lowest expense ratio. They all have very similar asset class exposure and are all more small cap and value oriented than the Vanguard Small Cap Value Fund (VISVX). (See recommendations). 

Does the success of small caps hold up if you exclude the 1930s?

Q: I have read the long term success of small cap stocks is due to a couple of great years back in the 1930s. Does the small cap premium still hold up if the great years in the 30s are excluded?

A: Yes, and the results get even better.  From 1928 to 2014 the small cap blend and small cap value returns were 12.2% and 13.6% respectively. It is true there were some amazing years for both asset classes during the 1930s. For example, the small cap value index made 125.2% in 1933 and 65.4% in 1936. But there were also big losses for both small cap asset classes. Small cap value lost 54.6% in 1931 and 50.6% in 1937. Putting the 1930s behind them, how did these two asset classes do for 1940 through 2014? Small cap blend made over 14% and small cap value made almost 17%. Get rid of those great years in the 1930s and the returns get significantly better. 

Are you ignoring growth stocks and funds?

Q: There are some great growth funds, but you appear to ignore the growth asset class and the great growth funds. What gives?

A: I have not ignored large or small growth stocks. There are lots of great growth companies and they should be represented in your portfolio. But historically these growth companies are not as profitable as the great value companies. Here are the facts: According to the Dimensional Funds data base, from 1975 through 2014 the large cap growth index compounded at about 12.5% vs. 15.4% for the large cap blend index. And, for the small cap growth index: 15.9% vs. 19.5% for the small cap blend index. Many investors believe that popular growth companies should make more money than out-of-favor value companies. That would be like believing small risky companies should make less than large successful companies. It may be counterintuitive, but the riskier the company the higher the expected rate of return. If small and out-of-favor companies didn’t have higher expected returns, investors would be making a huge mistake to ever put money into riskier companies. The good news is there is a long history of smaller and more value-oriented companies making a lot more money, as it should be.


How much of each of the small and large asset classes do you recommend?

Q: How much of each of the small and large asset classes do you recommend?

A: By the time I finish the series on performance, I will have discussed U.S. and international large and small blend (mix of growth and value) and large and small value without growth. The end result is the portfolio will be over weighted to value. The portfolio will also have a position in REITs (in tax deferred accounts) and emerging markets. So, in most cases I am trying to build a portfolio of 10% each in 10 different equity asset classes. As you review mymutual fund recommendations and ETF recommendations you will find not all portfolios have all 10 equity asset classes, as the fund or ETF families don’t offer those asset classes. For my personal investments I am able to access them all through Dimensional Funds. 

What’s the real return of small-cap funds?

Q:  I have read the premium of small-cap stock funds is simply the extra return for taking more risk. Is this really a premium or simply the return an investor should get for taking more risk?

A: Small-cap stocks are very risky to own one-at-a-time. Small-cap companies have a higher risk of default (complete loss) than larger companies. Just as I don’t recommend individual large cap stocks, I don’t recommend individual small-cap stocks. The academics have wisely pointed out that the long-term return of a single small-cap company is the same as 1000 small-cap companies, so it only makes sense to own them all. Of course, that’s what an index fund does. Here’s the huge benefit of diversification: When you own 10 different equity asset classes, and each equity asset class is broadly diversified, the risk of any one of the equity asset classes is greatly reduced. This is not so different from owning one small-cap value company vs. 1000 small-cap value companies. Diversification is the ultimate “free lunch.” The bottom line? The addition of broadly diversified small-cap blend and small-cap value asset classes raise the return more than the additional risk they represent on their own. 

At age 64, how much of my portfolio should be in small cap value?

Q: I’m sure most of your readers would like to put all of their money in a small cap value fund but I’m 64 and expect to retire in about a year. How much of my portfolio should be in small cap value?

A: I can’t know without knowing a lot more about your financial situation and investing experience. Maybe this will help: I am 71 and I have half of my investments in equity funds and half in fixed income (bond) funds. In the equity portion, approximately 10% is in a U.S. small-cap value funds and 10% is in an international small-cap value fund. I also have 10% each in U.S. and international small-cap blend funds. This totals 40% of the equity part of my portfolio and 20% of the entire portfolio in small-cap funds. If that is too much risk then an investor should probably add more fixed income. 

My 401(k) has only one value fund offering… what should I do?

Q: I’ve seen several of your articles that stress the advantages of diversifying into value funds, both large cap and small cap. My 401(k) plan only has one value fund available: TRP’s Mid-Cap Value Trust. Is there anything special one should know about investing in mid-cap stocks, and would you consider it an appropriate fund to include along with the Vanguard large (domestic and international) and small blend index funds that I’ve invested in to this point?

A: The good news is the T Rowe Price Mid-Cap Value Trust has a very fine track record. For the last 15 years it has compounded at 12% vs. 9.3% for the average mid-cap value fund. In any asset class, investors may have the good fortune to invest in one of the most profitable in the group. In the case of the TRP Mid-Cap Value Fund they ended in the top 9% for 15 years. The bad news is they have been in the bottom 37% for the last 5 years, I would not expect the fund to be in the top 9% in the next 15 years as the average size company is 3 times that of the average small-cap value fund and their price-to-book ratio is higher than the average small-cap average P/B. Plus, their .80% expense ratio is fairly high. With all the challenges the TRP fund has, it is still a reasonable mid-cap value fund, just not built to be a great small-cap value fund.