To afford an assortment of life’s wants and needs, many investors seek to earn returns above those offered by the broad market. There’s nothing wrong with that, as long as your resulting investment plan has been born of deep and careful consideration of your personal time horizons, risk tolerances and financial goals.
Therein lies the rub. Too often investors are instead tempted to replace structured strategy with heroic hope: guessing at which stock will be the next Apple; or jumping in and out of the market, trying to lasso the bulls and vanquish the bears. We would propose that this is really closer to speculating than investing.
Avoid the heroics. Investors are best served by understanding how to structure – and stick with – a carefully planned portfolio guided by their own personal goals and the robust evidence on how markets have delivered long-term returns.
Lessons from Morningstar
One key to a well-managed portfolio is to avoid making predictions about the future. Focus instead on investing across “asset classes” (a term for categorizing similarly behaving investments, such as stocks versus bonds, large-company stocks versus small-company stocks, etc.).
We were reminded of the importance of asset class investing when reading a recent Morningstar article, “S&P 500 vs. Total Stock Market: Which Is Right for You?” In a nutshell, the S&P 500 Index more or less tracks the 500 largest US companies by market capitalization. An S&P 500 Index fund invests in those same companies as a way to capture the returns available from them. A total market index fund also includes the much larger universe of small- and mid-cap companies. In other words, it includes more asset classes.
The Vanguard Total Stock Market Index Fund (VTSMX) is one example of a total market fund. Beyond providing broader diversification (approximately 3,200 vs. 500 companies), it outperformed the Vanguard 500 Index Fund (VFINX) over the most recent 15-year period by 0.4% (5.2% vs. 4.8%). It did so with slightly higher volatility, i.e., a bumpier ride for investors. But it does illustrate that the asset class of small-company stocks is expected to deliver a “small-cap premium” over the asset class of large-company stocks. We’ll get to why this expectation exists in just a moment.
Digging a little deeper, though, more intriguing insights arise. They become a jumping-off point for determining how to structure a portfolio to sensibly attempt to capture the various risk premiums the markets are expected to present to patient investors.
Further data dissection indicates the source of the excess return. Standing alone, the Fama/French US Small Cap Index returned 8.2% for the 15-year period from 1997–2011, revealing a 2.7% premium over the 5.5% return of the S&P 500 Index (these are pure index, not fund returns, so they don’t account for investment costs) — even larger than the historic 2% differential between them during the longer period 1927-2011. In other words, it seems plausible that it was the small-cap asset class premium that explained the majority of the excess return between the total market and the S&P 500 index funds.
The Asset Class of Forsaken Ones
Another asset-class risk premium worth trying to capture is the “value premium.” Value companies, in contrast to growth companies, are those considered out of favor, typically as measured by their price/earning or price/book-value ratios. This idea postulates that, over time, value companies are expected to outperform growth companies, similar to small-cap companies being expected to outperform their large-cap counterparts.
That “over time” disclaimer is critical, because evidence indicates it can sometimes take a long time for these types of premiums to shine through. The last 15 years includes the Internet bubble, during which large-cap growth companies such as Microsoft, Cisco, etc. achieved extraordinary returns. During this period, the value premium did not show up – at least not in large-cap stocks. The Fama/French US Large Value Index only returned 1.2% compared with the 5.5% return of the S&P 500. That said, the Fama/French US Small Value Index of unloved small-cap companies returned 9.8% during the 15-year period, and an impressive 13.5% for the full period from 1927–2011.
How to Seize This Opportunity?
First, seeking the rewards presented by these historical premiums comes with certain risks. (After all, they aren’t called risk premiums for nothing.) The first question one might ask: Are they likely to persist moving forward?
That brings us back to our discussion on why the premiums exist to begin with. For the most part, the answer to this question comes down to whether one believes this really is a story of underlying risk. We believe that it is, which is why we believe these types of asset-class premiums can be expected to persist. The risk of buying a single company that might go belly up can be practically eliminated by broadly diversifying across many stocks. Single-company risk is an avoidable risk. But the general risks of investing in small-cap or value stocks seem to be inherent risks that cannot be diversified away, no matter how many small-cap or value stocks you buy.
That is, aren’t small companies riskier investments than large ones? Aren’t out-of-favor value companies riskier investments than the average company? The theory says that both these kinds of companies have an inherently more difficult time attracting capital and are more likely to fail. Consequently, for those that do ultimately succeed (that is, become large or no longer distressed) their costs to attract equity capital (which exactly equals the return to shareholders) should be higher along the way.
Just One Helping?
As the Morningstar article shows, simply adding a market weight helping of small/mid-cap to a large-cap portfolio seems like a modest step toward diversification and expected enhanced returns. Integrating multi-cap exposure into one fund also is tax-efficient, eliminating transactions across funds when companies migrate from small to large and vice versa.
How About Seconds? Or Even Thirds?
But what if you are hungry for more than a market weight exposure to small-cap or value in your portfolio – adopting what we call a “tilt” toward small-cap and/or value stocks as a strategy toward increasing returns in your equity portfolio? Now we have to find a method and the investment vehicles to execute the strategy.
A simple choice is to augment your portfolio by adding funds alongside your large-cap or multi-cap fund to increase the proportion of these asset classes above the market weight. There are small-cap index funds, large-cap value index funds and small-cap value index funds offered by numerous fund companies in both open-end and ETF varieties.
This may be an especially good choice if you are out of room (or don’t have these choices) in one of your accounts, such as a 401(k). You could add one or more of these funds to your overall portfolio by including them in your IRA, Roth IRA or taxable investment account – and then remember to rebalance so that you maintain the desired weight of these asset classes. Another choice is an integrated solution like the ones offered by Dimensional Fund Advisors (DFA) in their core strategies, http://www.dfaus.com/strategies/us/, allowing you to seek and maintain your tilt from modest to extreme, depending on your appetite for risk and potential reward.
Testing Your Resolve
Before we wrap, we would be remiss to ignore an underlying investment risk called tracking error. Tracking error occurs when your portfolio, carefully structured according to your personal goals and risk tolerances, doesn’t behave like “the norm.” During the periods when your portfolio is underperforming the rest of the market (when it’s tracking differently) you risk losing your resolve and abandoning ship at the worst possible time, when prices are low.
Tracking error plays a particularly strong role in asset-class investing because small-cap and value companies tend to zig when others zag — sometimes for decades. Adopting a strategy seeking to capture these returns requires both a steely nerve and a really long-term horizon. You have to be prepared to wage a psychological battle with yourself during the periods of inevitable underperformance.
For example, during the aforementioned Internet bubble (from 1995-1999), when the Fama/French US Large Growth Index achieved an astonishing average annual return of 31.2%, the Fama/French US Small Value Index earned less than half that amount and even had negative returns in 1998 and 1999. Just when a well-diversified, but fainthearted investor might have reached the point of capitulation – right before the bubble burst — and abandoned a diversified strategy, small-cap value would have saved the day – achieving a remarkable average annual return of 20.4% from 2000–2003, when technology investors were pulling their hair out.
Investing Versus Speculating: A Recap
So go ahead, seek those market premiums. But do it as an investor, not a speculator. Speculators stretch for extra returns by trying to outsmart a highly efficient market. Investors effectively harness that efficiency toward their own ends. They build disciplined, low-cost portfolios, structured for their willingness, ability and need to take on market risk and its commensurate expected premiums. They then stick with their plans by ignoring tracking error that could knock them off-course. In so doing, investors can expect to be the true heroes in the end.