My thoughts on Small-Cap and Value Stocks

People have often asked me what I think about value and small-cap equity portfolios. So, this is a post I always wanted to write but kept postponing because I never knew how to best frame it. But now I have the perfect excuse to write it; last week, I listened to the ChooseFI podcast and they had Paul Merriman as a guest in episode 130. Paul Merriman is one of the big proponents of small-cap and value stocks. Of course, they talked about a variety of topics and I thoroughly enjoyed most of the discussion. I’m completely on the same page with Paul, Jonathan and Brad on a wide range of issues. For example:

  • Choose index funds over actively managed funds
  • Take emotions, especially fear and greed out of investment decisions
  • Young investors benefit from Dollar Cost Averaging. Specifically, a market crash early in your investing life can even be beneficial, at least under specific assumptions, as I wrote earlier this year in “How can a drop in the stock market possibly be good for investors?
  • Young investors shouldn’t even think about bonds in the portfolio when starting out. Use 100% equities, use as much risk as possible.

But there’s one thing I vehemently disagreed with! Paul Merriman seems to suggest that by using a “better” or “smarter” equity allocation, specifically, overweighting the value and small-cap styles – both domestically and internationally – we can increase our expected return by two full percentage points a year. And just to be sure, this is not stock picking but simply asset class/style picking, all implemented with passive ETFs. Two percentage points of extra return? Let that sink in! 2% a year can compound to a large sum over the years and then you retire and you get extra 50% of withdrawals when you add 2 percentage points to your 4% safe withdrawal rate. Pretty impressive! There’s only one problem: Merriman’s recommended portfolio didn’t return those two extra percentage points over the past few decades. And there are good reasons to believe that you will not gather those 2% extra returns going forward either. Let me explain why…

Side note 1: Brad and Jonathan are obviously good buddies of mine. Rest assured that I sent them a courtesy email to give them the heads-up before publishing this. So there should be no hard feelings (I hope) from their side.

Side note 2 (August 2, 2018): The ERN blog was nominated for the 10th Annual Plutus Awards in two categories: Best Financial Independence/Early Retirement Blog and Best Series: Blog, Podcast, or Video (specifically, the Safe Withdrawal Rate Series). Thanks to the growing community of all the amazing readers here who nominated my small blog!

Background: The value and small-cap factors 1926-2019

Value stocks and small-cap stocks have been studied in finance for a long time. The most famous research comes compliments of Ken French and Eugene Fama. Actually, Fama’s contributions to the Econ/Finance field were so substantial that he was one of the 2013 Economics Nobel Prize winners. Along with Robert Shiller (yes, that Shiller who came up with the CAPE ratio) and Lars Peter Hansen, a fellow Minnesota Econ Ph.D., by the way!

In any case, back to the Fama-French Factors, I looked them up on Prof. French’s website, and here’s the cumulative return of the size and value style premium, see below. Wow! Small-cap and Value did indeed have a wonderful outperformance run over the last 90+ years. And remember, this would have been the performance over and on top (!!!) of your equity index return. We’re now looking at some astronomical outperformance! No wonder this is so popular!!!

ValueSizePremium Chart01
Cumulative (compound) returns of the Fama-French SMB (small minus big) and HML (High book value minus low) factors. Source: Prof. Ken French

But notice something else in the cumulative return chart? The performance has started to sputter a little bit over the last few decades. The size premium has been flat since the early 1980s. The Value premium started a nasty decline in December 2006. So, let’s look at the return stats over the entire history and then also since 1984 (the peak of the SML premium) and 2006 (the peak of the HMP premium), see the table below.

ValueSizePremium Table02
Fama-French style premium stats since 1926 and for shorter windows. Source: Prof. Ken French

Over a long history, the two styles provided significant excess returns. The t-stats for the mean return were 2.15 and 3.44, respectively and the annualized CAGR excess returns were 1.89% and 3.68%, respectively. But this all looks a lot less impressive now. Small-caps were flat, even slightly down since 1984 and even though Value still performed well, its mean return is no longer statistically significant. Since 2006, Value got hammered (though still not significantly!) and Small-caps were very slightly positive. In light of the recent performance, I’d be cautious about taking the mean style premium results over the entire 91+ year period and extrapolating them forward.

Side note: I’m aware of the irony. In my post a few weeks ago I pointed out the dangers of looking at short horizons and picking convenient start/end points. But to every rule, there’s an exception. I think here we have an example of a structural break in the data where you want to be cautious about keeping the old and irrelevant data in the sample.

How did the Merriman Ultimate Portfolio perform?

Given the underwhelming recent performance of the two styles, I wasn’t expecting much. Well, checking out Merriman’s website I was hoping for at least some numbers. But I couldn’t even find any detailed simulation results. Strange! So, if someone could help me out and find a Merriman-approved return simulation with industry-standard return stat tables please let me know. Until then, I’ll have to use what I found on the web. Here’s a site “Portfolio Einstein” that put out 1-year, 10-year and 30-year simulated returns (all windows ending in 2018). But the Ultimate and Best-in-class portfolios were really not that great. They underperformed the simple passive benchmark over all three horizons. And this writer seems to be a fan of Merriman and writes a glowing review about this approach despite the underperformance, so it doesn’t look like this site wants to make the returns look bad…

Merriman Ultimate and Best-in-Class ETF portfolio performance as of 2018. A significant underperformance relative to the S&P 500 benchmark. Source:

Update 6/13/2019: As someone pointed out, the underperformance of the current Merriman portfolio relative to the S&P 500 index comes mainly because of the different country allocation. If we compare the Merriman portfolios to benchmarks with 50% U.S., 50% non-US or 40% US total market or alternatively – even closer to the 10-ETF portfolio – 40% US Total Market, 40% non-US-developed, 10% US REITs, 10% Emerging then the Merriman portfolio is still much worse over the last year (2018), about on par over 10 years but much better than the US+international benchmark over 30 years. But still: the outperformance came only during the early period.

ValueSizePremium Table03
The Merriman portfolios looked much better if compared with those having similar country allocations. About on par with the non-small-cap-value portfolio over 10 years, and much better over 30 years. But again: all of the outperformance came from the early period! Source: Portfolio Einstein,

Where does the 2% excess return number come from?

Honestly, I don’t know. It’s the first time I ever see an actual hard number from the small-cap-value crowd. Again, maybe it’s information overload with so much material on the Merriman website and I didn’t find the exact source and careful, understandable and replicable calculation. Please provide a link to the calculation if you know where the number came from.

Until then I can only speculate. The source of the 2% figure could be this page where they introduce the new March 2019 Merriman recommendation, also mentioned in the podcast. If you scroll to the end of the page you can spot the table with a “Factor Analysis” and the 10-fund ETF portfolio has estimated factor betas: 0.37 for small-cap and 0.23 for Value. If we apply the SMB and HML average excess returns since 1926 (1.89% and 3.68%) and multiply with the appropriate factor loadings (0.37 and 0.23) then you get 1.89%x0.37+3.68%x0.23=1.5457%. The portfolio also had a higher than 1.00 market beta (1.08, to be precise), so if we add another 0.08 times the equity risk premium (say, 5%) you’re right there at around 1.95%. 

But this calculation is really, really troublesome. I don’t think that even Fama and French would argue that the 90+ year average return is to be blindly applied going forward, almost like a physics constant. There is a very active discussion in finance, both in academia and among practitioners, about whether the size and value abnormalities have disappeared or not, but even the staunchest supporters of the idea that the premia haven’t disappeared would concede that you’ll no longer earn 3.68% from value over growth going forward. So, if anyone extrapolates the long-term average alphas my “bullshit alarm” goes off. But again, maybe there’s a good explanation for the 2% excess returns.

Explanations for the style return pattern

What explains the recent underperformance of the Fama-French factors and the Merriman portfolio? Here are two possible explanations:

  1. Bad luck. This is obviously the explanation that Merriman and his crew hope for. Over short horizons, but even over several decades, a bona fide alpha source can have a streak of bad luck. If this is the case, don’t worry about the poor performance over the last 30 years. A return to consistent outperformance in the value and size premium should be right around the corner!
  2. The party is over. There was a market anomaly that created the excess returns for both small-cap and value stocks during the early years. But this anomaly has now been detected, it has been studied in detail, it has been widely publicized in both academic and practitioner journals and it’s now even widely known to the average retail investor. Thus, the arbitrage opportunity, in the best case, has been watered down or, in the worst case, has been completely arbitraged away. Curb your expectations going forward!

Which one of the two explanations do I find more compelling? Merriman disciples will hate me for it but I’m afraid I’m leaning toward option 2. The small-cap value party is likely over. Now, I am not trying to say that SCV will underperform going forward. I am merely saying that a 2% excess return seems unrealistic. Going forward, I’d still expect a little bit of extra return, just a lot less than the historical averages – more on that later!

Why the style premium party might be over (or at least a lot less profitable going forward)

A lot of institutional money has been flowing into exactly the styles Merriman favors. And all the other styles that are en vogue right now: momentum, quality over junk, low volatility, minimum volatility, low beta over high beta, just to name a few. Once these style premia go mainstream and there’s an ETF for it (plus hundreds of billions of dollars of institutional money) some or most or even all of the style alpha will be arbitraged away. It’s how efficient markets work. So, I just have trouble rationalizing that a 2% extra return from a completely static/strategic bias to passive indexes will persist forever.

More on the size premium

Imagine you had known about the size premium before Eugene Fama and Ken French published their path-breaking research. You’d now kick yourself that Eugene Fama “stole” your Nobel Prize 🙂 but at least you would have made a lot of money, right? Well, maybe not! It would have been hard to “harvest” this premium. Remember, before the advent of ETFs and internet trading platforms you’d call up your broker on the phone. Mutual funds were available but often had loads and high expense ratios. How exactly would a retail investor have constructed a portfolio replicating the Russell 2000 index, a popular small-cap benchmark with 2000 constituents? Hey, I have $1,000 to invest this month, can you please buy the 2000 stocks in the index? Hard to do as an average Joe retail investor.

Side note 1: Actually, before the famous Fama-French work, Rolf Banz is credited with pointing out the size premium for the first time (to my knowledge) in 1981. And right after the publication, the whole thing stopped working. A coincidence?

Side note 2: The comment that Fama stole “your Nobel Prize” was tongue-in-cheek. In fact, Fama didn’t even win the Prize for the Fama-French research but for his contributions on the “Efficient Market Hypothesis”

Institutional investors would have had fewer technical constraints than the average retail investor harvesting the size premium. But many had compliance/legal/regulatory constraints. Endowments and pension funds were often constrained about how exotic they could go in their domestic equity allocation. Right around the time when some of those constraints abated and the market became less segmented is when the size premium lost its luster. Coincidence? You be the judge!

But just for the record, I certainly concede that even today there is a justification for at least some size premium due to less transparency, less analyst coverage, higher macroeconomic risk (small stocks often get hammered more during recessions/bear markets), etc. I simply don’t believe that the size premium can be as large as it has been historically. More on that later!

Update 6/14/2019: Someone pointed out – quite correctly – that the 20-year return of small-cap looks really good. The reason is easy to spot, see that chart below. Small-caps initially underperformed during the dot-com bust, but then didn’t drop as badly. But over the last 15 years, the two indexes tracked each other extremely well again, including the Global Financial Crisis.

ValueSizePremium Chart03
US Total Market (blue) vs. US Small Cap (red). The two lines track each other really well but deviate a bit around the dot-com bust, only to exactly track each other again during the Global Financial Crisis. Source:

More on the value premium

One thread going through Merriman’s media appearances and especially the ChooseFI podcast was the idea that value stocks deserve a premium because they also involve more risk. More risk means more expected return. Every investor knows that, right? Of course, the truth is a little bit more nuanced. Shorting a stock market index has the exact same standard deviation but much lower expected returns than being long the index. So, the expected return is not just tied to risk but also when the big drawdowns happen. (side note for the finance geeks: for expected returns, it’s not so much the risk but the market beta that matters for expected returns)

Historically, the value over growth premium had very sharp drawdowns right around the big recessions and bear markets. Look at the cumulative return chart above; value stocks underperformed growth stocks during the Great Depression, during the 1970s, 1980s recessions, and 1991 recession. So, because value stocks underperform when it hurts the most, one can justify the extra return. So, just for the record, this return pattern most definitely justifies a return premium!

It even looks like the value over growth style continued this pattern during the dot-com bust and the Great Recession. But nothing could be farther from the truth! Value stocks underperformed before the year 2000 market peak by a whopping 44%. Actually, the worst underperformance of the Value style happened during the craziest part of the internet bubble! And then Value rallied again by 80% during the dot-com bear market, so the whole risk premium story goes out of the window. It’s the other way around: value stocks were a hedge against the 2001-2003 bear market! Instead of demanding a risk premium you should pay an insurance premium.

The experience during the Great Recession (Dec 2007 – June 2009) and the associated bear market (October 2007 to February 2009, when using month-end data) is also very atypical. Sure, you lost 18% during the 2007-09 bear market but the decline of the Fama-French HML factor was a long slog, a decline of 36% since the peak that spanned an entire business cycle (the late expansion before the recession, the recession and bear market and 10+ years of recovery. Very different from the return patterns before.

So, in other words, if this fundamental “more risk, more return” story was the explanation for the excess returns it went up in smoke over the last two major market events.

Another problem with the value/growth classification: sector biases

I looked at the sector weights of the iShares Core S&P U.S. Value ETF (IUSV) and the iShares Core S&P U.S. Growth ETF (IUSG) and noticed that value and growth stocks have wildly different sector weights. Value stocks have a large overweight to financials and energy but much smaller weights in IT, Health Care, Consumer Discretionary and Communications. Why does this matter? If we believe that we’re in the middle of another industrial revolution that will boost certain sectors and threaten the decline – even demise – of others then it becomes dangerous pinning your hopes on out-of-favor sectors and industries coming back in favor.

ValueSizePremium Chart02
Core S&P Index Sector Weights. Notice that the large sector biases: Growth overweighs IT, Health Care, Consumer Discretionary and Communication and underweighs Financials. Source:

Notice how this sector story also points to a potential “solution” for how to make the value over growth premium “work” again. I would certainly like to invest in a value fund if it didn’t have those sector biases. So, instead of looking for low price-to-book stocks over the entire universe, why not construct an ETF that has the exact same sector weights as the index, but then within each sector (and maybe even subsector) you do the value bias and buy the out-of-favor stocks measured by the P/B ratio. And you do it for the exact reason that Merriman uses. So, don’t get me wrong: my core investing philosophy is actually close to Merriman’s, i.e., relying on value and valuation. I just believe that the reversion to the mean argument, i.e., out-of-favor stocks going back in favor, is a lot easier to make within sectors than across sectors!

What would be a reasonable excess return estimate for Merriman’s Ultimate Portfolio?

There is a saying in economics (and I’m sure in many other fields as well): “it takes a model to beat a model!” So, I can’t just criticize others and walk away. I certainly want to understand how much extra return you can expect to make from implementing the Merriman portfolio tilts. In other words, if we start with a portfolio comprised of 40% U.S. Total Market, 10% U.S. REITs, 40% ex-U.S. developed and 10% Emerging Markets without any size or value tilts and we move to the Merriman 10-fund portfolio with all the size/value mumbo jumbo, how much can I expect in extra returns?

I looked at the 2019 long-term market return outlook pieces of two asset management shops I trust: Bank of New York Mellon and JP Morgan. What’s their opinion on the size and value premium?

  • Size: BNYM uses a premium of 0.6% p.a. of small stocks over the total market (6.9% Russell 2000 over 6.3% Russell 3000). JPM doesn’t report a separate category for the Total Stock Market but if we weight the values for large/med/small (5.25%, 5.50%, 6.00%) and use a 5.4% blended return for the overall market then we get – miraculously – the same 6.00%-5.40%=0.60% premium of small-cap over the total stock market. Also, quite intriguingly, BNYM reports separate figures for MSCI World ex U.S., both the broad market and small-cap and estimates zero small-cap premium there!
  • Value: BNYM doesn’t report an expected return for value stocks. JPM uses 6.00% for value stocks, which translates into the same 0.60% (=6%-5.4%) value premium over the total market (which then implies 1.20% for value-over-growth).

Well, these are quite a bit smaller than the 90+ year averages from the Fama-French data! Of course, I can already hear the Merriman disciples complain: these are the evil Wall Streeters. But why would Wall Street try to hide the small/value premium? If anything, wouldn’t they have an incentive to overstate those style premia? After all, they charge higher fees managing the more exotic styles. Well, in any case, if we now assume 0.6% extra return from small-cap and value tilts, what kind of an impact would that have on the Merriman portfolio? That’s what I do in the table below. And that’s assuming I can translate the same small-cap alpha to international stocks even though BNYM assumes a premium only for domestic stocks but I’m feeling generous today.

ValueSizePremium Table01
Estimated extra return in the Merriman 10-ETF portfolio. Assuming a 0.6% extra return p.a. for all styles value/fundamental and 0.60% extra return for all small-cap styles.

So, I get a 0.54% extra expected return per year.  But that portfolio would also have a 0.28% expense ratio. I could construct a 40% U.S. Total Market portfolio plus 50% world ex-U.S. (both developed and emerging) using the zero-expense Fidelity Funds. The 10% allocation to Vanguard’s VNQ would contribute 0.012% to the overall expense ratio (12 basis points times 10% weight), so we would cut in half the excess return to about 0.27%. Not quite the 2% that Merriman promised. With a quarter percentage point annual alpha, this small-cap and value stuff makes it onto my maybe pile. At most!

You want the value premium to work again? Careful what you wish for!

You know what it would take to bring doubters like me on board again? During the next (!) recession and bear market, value stocks get totally clobbered! Just as Paul Merriman said on the podcast: More risk implies more return. Value stocks are more exposed to macroeconomic shocks. But do you see the irony in that? In order for value to be considered a bona fide risk premium again, we’d have to see a big drawdown to undo the damage from that strange behavior of the value premium during the last two recessions. Then why would I want to invest in value stocks now? Wouldn’t it be safer to wait until after the next recession and bear market? Why would I want to take that risk? After a 10+ years bull market and the longest macroeconomic expansion on record, the next recession plus bear market may not be so far away, so why should I be in a rush and take the risk? For a measly 0.27% annual alpha?  I got time on my side and I’ll decide whether and when to dip my toes in value stocks right around the time the total stock market is down 30%+!

Let’s all become market timers?!

Here’s another irony in the whole Value stock discussion. Notwithstanding the fact that I don’t see much of a reason to strategically shift into value stocks (yet), I totally admit that there’s a case to tactically shift into value stocks. What do I mean by that? Your strategic asset allocation is the very long-term target allocation, while the tactical allocation would be the short to medium-term shifts in the allocation due to market timing. And thanks to the very long drawdown in the value premium, value stocks now look really cheap. In other words, forget the very long-term return assumptions that the strategic allocators would use (see the BNY Mellon and JP Morgan numbers above) but instead use the estimates that the short- to medium-term asset allocators would use – the market timers. This expected return gap between value and growth is indeed quite large today, compared to history. So, just from a purely short- to medium-term perspective, there would be a rationale to dip your toes in value stocks because the valuation of value stocks (pun intended) looks attractive now. But you better make sure that you get out again before the next bear market, see the point I made above. But I’m not sure Merriman and his followers will like this rationale. Remember, it involves market timing (!), which he considers a big no-no!


I’ve encountered several Merriman followers while blogging here and they are certainly emotional about this approach. I don’t think I wrote anything too controversial today but I’m definitely bracing for a bit of a sh!tstorm from the small-cap-value crowd. Some will call me one an evil, dishonest Wall Streeter. Some might call me one of those dogmatic VTSAX investors, which I’m certainly not. Quite the opposite, I’m pretty open-minded; 35% of our portfolio is in my options trading strategy and 10% in real estate. If there’s an opportunity to beat the market, I’ll be all ears!

Both sides, the totally passive equity indexers (much of the FI community, Bogelheads, etc.) and the small-cap-value crowd will probably not agree on anything anytime soon. That’s because we have different portfolios to start with. And being in this “statistical limbo state” where I don’t see enough evidence to start a Merriman Ultimate Portfolio and they don’t see enough evidence to dump their Merriman Ultimate Portfolio we’ll probably coexist for a while. Deal with it! But I like to pose a question to the Merriman crowd:

What would it take for you to change your portfolio back to just the passive broad index ETFs?

It’s a question that Jonathan and Brad maybe should have asked Paul on the podcast. I told you what it would take me to change my mind: I’d like to see a sector-neutral value fund (haven’t found that one yet, please let me know if you know of one). I’ll shift to small-cap and value (and even small-cap-value) after those styles get clobbered in the next bear market. And then, hopefully, I’ll make a ton of money in the bull market that follows. But my question for the people on the other side of the argument: How many more years of underperformance can you take? 5 years? 10 years? 30 years? Have you ever even thought about that question? It’s what academics do, right? They try to challenge their theories not look for confirmation. So, that’s what I want the style premium investors to think about: What would it take for you to throw in the towel? Looking forward to the comments on this one!

Hope you enjoyed today’s post! We’re traveling right now and might be late replying, but I will read every single comment here and I will reply to every comment. But please keep it civil! 🙂

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135 thoughts on “My thoughts on Small-Cap and Value Stocks

    1. Also while Paul Merriman considers market timing a no-no, he employs half of his own personal portfolio in a trend following system. I think what he is really trying to do, is what the Choose FI folks are trying to do, make it as simple and with as little landmines in the way as possible. Over the years I have come to appreciate that approach, even though I run my own set of various strategies from trend following to a long short portfolio.

  1. I enjoyed this analysis quite a bit. For disclosure, I have been a SCV tilter for nearly 25 years, have read numerous books on the topic, and have become disillusioned by the underperformance. I mean, if you are not going to outperform in a generation, how long do you have to wait?

    My solution is not to sell out, especially in the taxable account, where there are a lot of embedded gains, but new money is being deployed exclusively in plain vanilla market weighted index funds.

    1. Thank you for doing that Big ERN, I was listening in disbelief as a potential 200 basis point outperformance was discussed.

      I kept waiting for the bit where it would be explained that the value premium had seemingly disappeared of late, perhaps after being recognized by the academic literature.

      There was a magic bean quality to the discussion that I think could have misled a lot of listeners.

      1. Very good point. Different people will “hear” different things. I hope not too many people rush to this Ultimate portfolio and then be disappointed when the 2% extra return don’t pan out.

          1. Thanks for the link! It’s troubling to look at a 40-year window with a 2% p.a. outperformance and use that almost as “scripture” for future outperformance. I was looking for some more structural reasons why this works, hence my attempt to gather expected returns for the different styles. 🙂

        1. Another, but somewhat related, point is that investing in small-cap value is somewhat inefficient due to higher expense ratios. Compare VTI (0.03%) with IJS (0.18%). There is VBR (0.07%), but it is not pure SCV and has substantial mid-cap component due to a different index. If the premium is due to stocks with very small market-cap VBR may not fit the bill. Other ETFs/funds are expensive/low trading volume. This 0.15% difference plus any trading costs due to stocks moving in/out of the index has to be overcome by the premium.

    2. Yeah, good point. No point doing anything tax-inefficient. And, hey, maybe the outperformance is just around the corner… I don’t want to rule it out. Only the 2% p.a. seems a bit high.

  2. Thanks for this! I still held to the belief that a Fama-French portfolio would outperform, although I’ve stuck to total market funds regardless. Glad to know small cap value has not continued to outperform indefinitely.

    1. Thanks. Just like you I had heard about the F-F factors but never changed my investing style reagrdless. Seems to have been the right decision over the last few years! 🙂
      Cheers. And “Prost” as we’d say in Germany!

  3. Being overweight Financials is a huge problem for value etfs (or any value portfolio). The other is having quality screens on your value plays. That’s two of the reasons why I think value investing is a stock picker’s game. It’s best done on a stock by stock basis looking at each stock’s roe, rotc/roa, eps trends, and market position. It also helps to keep a strong focus on consistent dividend payers and growers when looking for value plays. That’s essentially the Warren Buffett strategy, but I think it’s incredibly hard to emulate in an etf or mutual fund, especially since you need to be willing to hold a lot of cash when you can’t find anything really attractive to buy.

    1. Wow, that’s a great comment! Couldn’t agree more! That’s because Buffett is the ultimate (pun intended) value investor. But definitely relying on careful stock picking, not the naive P/B ratio sorting.

    1. To bad they don’t trade. I was gonna add some to compliment my IWM short. The spread is atrocious.

  4. Was hoping Brad and Jonathan were bringing you on in the roundup. I was surprised when the roundup became a pro-small/value discussion and a simple path for folks to create the portfolio through M1. There was no critique or questioning of the 2% premium Merriman practically guaranteed people. I think Merriman has great intentions but my (mild) BS alarm was going off a bit throughout the interview.

    Once again your opinion lines up right with mine. I’ve poured over the research into small/value and came to the same conclusions you did (though w/o fancy modelling). I understand though why it is a heavily debated subject, of which you will find many proponents who also consider themselves Bogleheads. While I think some exposure might be fine, the idea that young people should be 80-90% small/value seems like a risky bet.

    1. Very good point! By the way, even Fama and French don’t believe that these premia are guaranteed. Especially Fama, who’s the great efficient market guru.
      Thanks for stopping by Jazz&Lee!

  5. I agree with you on the decline of the expected return of the value premium but there is another important issue IMO is the implementation of the value premium in portfolios & how close the implementation is to the data underlying the premium. There are lots of specific assumptions in the implementation (things such as screening out of certain types of stocks, market weight vs. equal weight, the ability of large funds to buy SCV without moving the prices) of SCV that the difference between theory & practice can be very high, let alone the management fees for SCV funds. I can see these eating up any additional premium that may be left over for investors in these strategies.

    There is also the issue of growth. The P/E of a stock is proportional to its growth in earnings, per the Graham formula of P/E = 8.5 + 2g. In the discussion of value (& how cheap it is), I see very little discussion of growth but this is very important as Buffet has said growth & value are joined at the hip (by the Graham formula above). If we look at Vanguard SCV & Vanguard 500 the P/E difference is only 3.7 points, SCV (14x) & 500 (17.7x) per Morningstar. Most of this difference can be accounted for the differences in LT Earnings Growth, SCV (9.6%) and 500 (10.8%). 3 P/E points can be explained by deltas in growth if we include the change aaa interest rates between the date the formula was published and today (3.5% today vs. 4.4% when the formula was derived.


  6. If anything I’ve been Growth tilted because I’m wary of the extra taxes on dividends that a Value tilt would bring (I’m in a fed high tax bracket and have to pay steep CA taxes on top).

    But your post has got me thinking, and I’ll admit I’ve never done the math on this to see how much of a benefit this tax avoidance would have or if I would actually be better off Value tilting (or not tilting at all).

    Have you ever quantified this impact?

  7. Thanks for the interesting commentary. But regarding the lagging results in the portfolio Einstein table, it’s misleading to blame the small & value tilts in the Merriman portfolio. It underperformed the S&P 500 because it was 50% international (it had nothing to do with the tilts).

    From 1989-2019, a 50/50 mix of large cap US and large cap international funds had a CAGR of 7.26%. This below the small-value tilted performance of 8.8% in the Merriman portfolio during this period. If you make an apples-to-apples comparison in terms of international diversification, the tilts did work more or less as expected during this period.

    1. Very good point. I added the different benchmarks and indeed, the 30-year return comparisons still look good. Not a big surprise, because the Fama-French styles also look good over a 30-year horizon.
      Thanks for pointing this out!

  8. I stumbled on Merriman’s model portfolio and basically copied that for my own asset allocation very closely. Last I checked my expense ratio was 0.17% and it’s probably dropped a few bp since vanguard keeps lowering them! International Value is the main killer – active management for 0.4% ER but it’s a small slice overall.

    And I was hoping for nothing more than 0.5-1% outperformance vs a plain old VTSAX/Intl allocation. Costs don’t seem too great – slightly higher ER on the portfolio and lack of close tracking to VTSAX.

    As to your question – I’m not sure what would change my mind at this point! I’m not strongly tied to my asset allocation from an academic or religious standpoint but more out of laziness and momentum.

      1. Looking at my portfolio overview at Personal Capital, it says I’m at 0.19% ER right now. Glancing over the funds, almost everything is 0.18% or much less because it’s all Vanguard funds. 0.18% is the VNQI – International REITs. But only 5% of overall equities allocation.

        But the real killer that pushes the average up to 0.19% is VTRIX – International Value. Haven’t found a good alternative for that slice at its .38% ER. So I give up ~10 bps overall and *maybe* get 0.5%-1% or so return (minus the 10 bps) for the small/value tilt. Or not and I waste 10 bps on the gamble! 🙂

        1. I can’t believe what I’m hearing… I too had no idea and don’t know what to think now.

  9. Interesting – I tilt to value, small and some mid cap value but no way of knowing what the future will bring. I’m not 100% sold on value or small tilt, though not 100% sold on simply putting it all in total cap weighted market index either (might as well just invest in top 50-100 stocks and call it a day). The reason I tilt to small and value is conceptually it seems like it should work. As a person working at a megacorp I can tell you small companies have more runway/growth, less inertia, and ability to be bought out by stupid megacorps looking for ways to use their cash (driving up price). Value is interesting though I prefer indexes that apply some kind of quality metric (such as S&P 600 value). One would think paying a lower price for earnings over time would work well and that’s what would drive some of excess return, however, it appears a lot of it is timing/frequent trading:

    I believe Paul used to post a table out there that walked one forward from a pure 100% S&P to his ultimate buy and hold and looked at actual (hypothetical?) returns since the early 70’s and that’s likely where his 2% is coming from – pure guess though. I think he stopped last yr as he was paying Mark Hulbert to produce each yr but maybe you can email him or he’ll see this. He generally does seem like he’s trying to help people.

    Big Ern – great article as usual – though I’m still as confused as ever about whether tilting to value, small is worth it – I think because I already do so, I will just keep at it. I do like the diversification of weighting different asset classes vs. being all tied to the top 100 stocks or so in the US.

    I know the “value” and “small” tilt info is out there and theoretically the market should adjust, but the market is not perfect. If it were people would never put money into negative bonds overseas, markets wouldn’t rapidly decline/increase with little underlying economic reasons, and bonds would likely be paying more given returns available in equities (return reduction is too steep to account for the reduction in “risk” especially over long term).

    I do struggle with international as it is very cheap but performance has been horrific for many many years now. I’m 10% in int’l.

    1. Nice comment. Thanks so much for your story!
      I should stress that I don’t want to talk people out of SCV. My working assumption is the expected return is similar or not noticeably higher with SCV than with the braod blended index. If you have SCV and you’re happy with this then stick with it. I only have a problem with the 2% p.a. outperformance.
      Same here with international. Maybe after the next recession I will go in again. Hoping that the recovery in EAFE is better than at home. But even that’s hard to tell. Same story as with SCV: it’s a crap shoot! 🙂

      1. I agree -2% out performance is highly unlikely. What’s your thoughts on sites like and I feel like past returns are no guarantee of the future, but I also wouldn’t necessarily want to pick an asset class with poor historical performance (commodities, etc.)

          1. Great website Karsten and thanks for the awesome, thought provoking articles. And I hate that my first post is to disagree with you a bit.

            It occurs to me that when using historical numbers you can either use the numbers to drive the narrative, or use the narrative to explain the numbers. I’m of the earlier persuasion. The data set at portfolio charts from 1970 shows significant premium for small cap over the total stock market and a rather jaw dropping premium for small cap value. Is that same premium going to continue? Will it continue at a smaller yet significant rate? Will it underperform? Who knows! Past performance is no guarantee of future performance. But the data over a fairly long time period seems to show that a premium has existed for small cap and small cap value.

            I like to point out that there is no guarantee that the stock market in its entirety will continue to deliver results that match or exceed inflation. Is there a Japan style stagnation in our future? A 1929 style crash and depression? Again- who knows! We might all find ourselves 20 years from now grudgingly admitting that the folks in 100% cash were the unsung geniuses of the 2019 investment world.

            1. Good points!
              Japan was hopelessly overvalued in the late 1980s, much worse than even the S&P today. So, I’m confident that equity returns > CPI going forward. How much? Probably not 6.7% real, but I’d be happy with 3% for the next 10 years. 🙂

  10. “Young investors shouldn’t even think about bonds in the portfolio when starting out. Use 100% equities, use as much risk as possible.”

    I think this is where the breakdown between what should work and what actually works occurs. The vast majority of investors don’t have the stomach for 100% equities no matter how much you and I think they should or might. Especially if they’re young! Many people go in nodding their head saying “Yes, yes, markets fluctuate, I know” and then freak out and often sell when the bear comes along. We often lose sight of the behavioral reason for bonds – to stabilize the account enough to stop someone from hitting the sell button.

    The best laid plan will fail if they don’t follow it!

    1. Yeah, but I always tell people that they should distinguish the %-risk and the $-risk. You may have 100% equities but with a $10,000 portfolio you have less $-risk than someone with a $1,000,000 portfolio and 60% stocks, 40% bonds.
      I think it’s our job as bloggers and members of the FIRE community to educate and hlp people who are not on board with the 100% equity portfolio. 🙂

  11. A couple minor points. The Ultimate buy and hold should be compared to a more similar allocation not just the S+P500 to show over or underperformance so like 50% US market 40% developed ex US 10% emerging markets. The second thing is that the expense ratios being higher can be somewhat less of an issue than it seems because small cap funds make back some of their expense ration in securities lending. For example Vanguard’s international small cap etf VSS makes back all of its ER in securities lending.

    1. Gotcha. Corrected that. I added a section with the different benchmarks, i.e., benchmarks with the same country allcoation but without SCV.

      About securities lending: Wouldn’t the VTSAX get the same securities lending income? I don’t think that the sec-lending accounts for much more than 0.01% anyways. But if you have hard data, please let me know where I can find that.

      1. The small cap funds get more relative to ER. I guess there is more short interest relative to availability in small cap stocks. It should be available in the annual reports but you can also compare the performance to the index the fund tracks. In the case of small cap funds it is common to see that it loses to the index by less than the expense ratio or even beats it..

  12. Big Ern,

    As always your analysis is impressive and thorough. Thank you for your work on the SWR series. Each post is a fantastic read and as a former engineer turned CPA, I appreciate the mathematical rigor into your analyses.

    I first discovered the Merriman Ultimate Buy and Hold portfolio about 2 years ago and it made sense to me. As he explains how each additional asset class contributes to both the return and standard deviation. To me, doing an annual rebalance of 10 etfs is not hard or time consuming.

    I do believe that the portfolio could be simplified into fewer funds, but I still follow the strategy because no one knows what asset class will outperform in the future. Even if the premium is only ~0.3%/year after fees, I still think it’s worth the additional work to rebalance.

    I think a good comparison would be to do a comparison of the US version of the Merriman UB&H (22.5% each S&P, LCV, SC, SCV plus 10% REIT).

    At the end of the day, we all need to determine what rate of return we need from our investments to achieve our goals. That has to be balanced with the risk we should and are willing to take, plus the time necessary to manage the portfolio. Even if the next 30 years are exactly the same as the previous 30, the rate of return is more than sufficient for me to meet my goals.

  13. I just nominated your blog for best early retirement blog and your SWR series for best series. It is the least I could do. This blog has become my go to source for all things FIRE since I retired a year and a half ago. Thanks for all you do for our community!

  14. Hi Karsten,

    I have nothing of value to add to discussion except that I want to occasionally make my contribution in letting you know that we all find these types of articles very informative. I feel like there is nobody out there writing for the FIRE/investment community with this much rigour.

    I am in complete agreement that any low hanging fruit would be easily arbitraged away.

    Like you, I still believe in fundamentals and value-investing, albeit I think we are more modern value investors than the traditional cigar butt sense.

    I stick mostly to agnostic market cap weighted index ETFs, and options (thanks you to you) even though most of my greatest returns have come from individual value stock picking. I am under no illusions that this is more to do with luck and while it is a higher absolute return, it is likely lower when risk adjusted.

    Where are you on holidays to this time around?

    1. I second that. It’s refreshing to have a more sophisticated investment discussion than ‘buy VTSAX” lol. I get it, their focus isn’t investing so much as the philosophy of implementing FIRE.

      Having said that, Karsten how would you design a simple yet effective investing strategy for the FIRE community?

      1. Thanks!
        Whatever you’re comfortable with. Go 100% VTSAX if that’s what you’re comfortable with. Or S&P 500 or a combination. But I don’t judge anyone for doing SCV. I don’t think it will UNDERperform. But I don’t think 2% outperformance are in the cards either…

        1. I agree, I am so very grateful to have a blog like this with heavy technical arguments. I am an engineer and I want to have the most optimized path that meets my risk tolerance. This article does diminish some of the shinny off of SCV, but I am still going to stick with my IJS as I love the diversity as it zigs while other stuff zags in my portfolio which puts me at ease.

      2. I totally get the “buy VTSAX” being most popular because it is the simplest and most efficient way for most people to not go wrong, and/or for people who don’t find investing interesting. I really enjoy Karsten’s approach where people like us who finds investing fun, can put in a little bit more work for a little extra benefit.

    2. Thanks, Bob! We’re on the same page philisophically! I also like to look at fundamentals, but this whole P/B sorting without regard for other metrics and sectors sounds fishy!

      Currently enjoying Venice, but heading out on a cruise ship to the Greek Isles later! Living the dream! 🙂

      1. You certainly are living the dream! You deserve it though. I can honestly say that the majority of my current understanding of implementing investments and FIRE, is thanks to your writings. Rigorous analysis of SWR, sequence of return risks, and options trading are just some of the things you’ve added to our community that is fresh and not just a rehash of MMM.

  15. Compare the Vanguard 500 index fund (VFIAX) with the Vanguard Small Cap Value index fund (VSIAX) on Morningstar over the last 20 years.

    Since 1999, the 500 index fund compounded 10 grand to $32,584
    Since 1999, the small cap value index fund compounded 10 grand to $59,316.

    I’m not sure where people are getting numbers.

    Go to French/Fama data on Dimensional Funds.

    Since 1926, $1 in Large cap became $7,025. $1 in Small Cap became $20,445.

    So…I dunno. I continue to be overweight Small Cap Value.

    1. Yeah. 20-year returns look good because of the bump during the 2000-2002 period. Overall, the small-cap premium was zero since the mid-2000s, see the “Update 6/14/2019” above.

      Again: Fama-French SMB factor did outperform, but all of the outperformance was largely before 1980s. As my first chart shows. Rely on this outperformance on your own risk.

  16. A narrative explanation for Value’s underperformance is that it occurred exactly when a technological revolution was occurring. Everything did well, but there were no Microsofts, Dells, Googles, Netflixes, Intels, Apples, or Amazons in the SCV index.

    So the relevant question is: Do you think the IT revolution has plateaued or do you envision consumer spending on tech to continue increasing as it has done for decades now?

    On the one hand, consumers cannot continue to indefinitely increase the percentage of their income and time spent on electronics and various data services. At some point, they run out of money/time for the $10,000 iPhone 31. Also, sometimes a technological direction meets its point of diminishing returns (e.g. airliners from the 1970’s look just like today’s).

    On the other hand, new products like self driving cars, delivery drones, smart appliances, VR, more efficient batteries, etc. are coming out in the next 10 years. Or perhaps another technological field like genomics, nanomaterials, healthcare AI, etc. will power another growth rally?

    Place your value vs. growth bets accordingly, or just hang out in VTSAX and let history unfold.

    1. One thing I would like to point out. It IS easier (and cheaper) then ever to run a small business right now then probably anytime in history. You have some much technology at your disposal that is extremely cheap. An example would be Square, how awesome is it that you can get a cheap tablet or phone and quickly become a merchant in a matter of minutes… That was very expensive and painful in the past. How about this blog, or ChooseFI podcast, those would have been very hard to do with limited funds in the past to reach so many people.

      1. Small cap publicly traded companies aren’t really all that small though. They are just small relative to other public companies

      2. Very good point! But small-cap PUBLICLY-TRADED companies still have a lot of obstacles through regulations, etc.

        But it’s definitely true that it’s much easier for small proprietors and mom and pop business owners to start a business.

    2. I think the technical revolution might have many more years to run. Not so much with more expensive iPhones but technology getting more and more important in the service industry via artificial intelligence and machine learning. I would hate to miss the party by betting primarily on value stocks… 🙂

      1. I think there’s a solid case for the tech revolution not being over, but the case for value is the possibility that all the future holds are better cell phones and other gadgets, different social media apps, different media consumption apps, etc.

        If that future occurs, and tech no longer increases economic productivity or captures an ever-faster-growing chunk of consumers’ paychecks, then all those tech stocks will do is struggle to maintain market share. Some of them will lose the struggle to innovative companies that are not publicly traded (just as Yahoo lost to Google several years before Google went public) and this will be a loss to growth stock investors.

        The “glad I invested in growth stocks” future looks like the big tech corporations spinning their core competencies into new product lines such as AI robotics and self-driving cars, biotech automation, space tourism, nanotech medical devices, and new payment systems. Consumer spending would shift away from value stock things like cars, housing, credit card interest, etc. and towards these new markets.

        I’ll not make a bet – but then again I own index funds which are very tech-heavy right now. Also, as we learned in 2000, value stocks are not spared when tech stocks go down.

  17. Such a good post. I own DFA funds some with tilts. They also have different trading rules so the total market fund is not required to sell a position immediately upon a stocks exit from the fund. Immediate sale results in a glut of stock which drives the price down abnormally low. What the study showed was if you wait 6 months the stock price rebounds to its proper valuation and then its time to sell, so having more efficient trading rules can arbitrage the return, If your fund operates passively but a little out on the perimeter you can take advantage. It doesn’t always win but it’s a win more often than loose strategy like counting cards in vegas.

    A second change is the switch to momentum investing. It’s hard to get any kind of big mo’ going in small cap value except on the off chance that sector gets hot. Small cap value does carry more risk. So does emerging markets. EM over decades under performs on return and is far more risky than US total stocks, despite its pretend “diversification” argument. In 2008 the market dropped in half many EM dropped 70-75%. If you drop in half you need 100% to get even. If you drop 75% the magic number is 150% in an asset that has crappy return in the first place. EM is about 85% correlated with US so when US takes a dive so does EM but since its risk is worse it falls farther and faster. Having lived through several crashes I’m of the opinion owning something like EM or maybe small value is a bit of a waste. My impression is the rise and dissent are asymmetric. One the way up these sectors lend to diversity but on the way down all arrows point into the ground and the correlations become 1.0 except the higher risk stuff falls farther and takes longer to recover often several years longer.

    I think part of the reason small value worked in the past was creative disruption and the resulting increase in market efficiency, but now disruption is merely consumed by the behemoths. How many small cap value plays just get bought up by Google and removed from the competition? There used to be 10K stocks now only 3K. I think that’s where the premium went and I don’t see it coming back. Why would it? My tactic now is to compare a USbond/USstock 2 investment portfolio to any additional added asset allocation like US Foreign REIT GLD BND and choose the investment that lays on the efficient frontier, which is the most return for the least risk. A 7% return 10% risk 2 fund is no better or worse than some combo fund of 10 sectors which yields 7% return and 10% risk. The more complicated portfolio looks spiffier but your just playing with yourself especially as a passive income index investor. The whole point of index investing is to capture market return at not more than market risk which is why I don’t believe in the bogglehead 3. In addition I do believe in some bonds in the portfolio because of the non correlated diversity and I believe in re balancing. Re-balancing forces on the way up selling some high to maintain the balance and that sell high value is stored in a non correlated asset. In the crash you re-balance and use the sell high stored value to buy low. The bonds further reduce volatility so a 50% drop in stocks might result in only a 30% drop for the stock/bond combo. To get even the 50% needs 100% recovery but the 30% needs only 60% before you are making new money. That aspect is SOR related. It’s nice we had a 10 year expansion but over 20 years the S&P is up like 4%/yr whoop de doo

    I’m also a fan of being invested as much as possible all the time. If the best you are going to do is market return for a market risk you are dying on the vine if your stuck in cash waiting for an entry. No risk no money making machine. Were I to do it all over I would invest in 2 funds USstocks and USbonds, which are nearly free to own, determine my AA invest every penny I could as soon as I could. re-balance as soon as I could claim LTCG or LTCL no short term, sit back and watch the money grow. As good as you’re going to do with a index portfolio. As I approached retirement I would change my AA to lower risk because a 40/60 pays nearly as well as a 60/40 but has considerably less volatility. When I was 80 I might consider more aggression. It’s pretty hard to run out of money when your 80. If you run out of money it’s because you screwed up at 50 shooting the moon with too much risk and hot doggin and being a tycoon. God save us from the tycoons. I traded options and commodities in my youth, made some good money but it took a shit ton of work to manage the risk. I traded on the mini-market (jackson street) in Chicago and those cats were burned outliving on cocaine and Quaaludes. I went to med school instead

    1. Wow, thanks, Gasem! Very, very good points!
      I like the cautionary tales about all those “higher expected return through higher risk” stories! EM is a good example where this this has not worked so well, as you point out!

      About creative disruption/destruction: That’s one of the things people in the value camp miss: If there were only two states: “in favor” and “out of favor” then I could understand the Merriman approach: buy the out of favor stocks, sit back and wait until they come back. But today, too many out of favor stocks go to a third stage: out of business (Sears, Toys-R-Us, etc.) compliments of the disruptors. This may explain the demise of the value premium over the last few years.
      Cheers! 🙂

  18. ERN – I don’t think I saw this in the comments, but there’s a third reason this no longer performs. Sarbanes Oxley compliance cost with being public as a small cap company. Technology stocks now stay private until they have $1bil or $10bil or more in valuation on the public market. However its not just them, I’ve had nice companies as clients who did $300mil in sales, had huge growth potentials, and made $25mil+ in net income. They can’t afford the seven figures in compliance cost as a public company and instead elect to sell to private equity. I’ve also looked at deals where a company is taken private and “delisting savings” is in the deck with the costs being so high. You probably have better data than me, I’d love to see a footnote on the number of public US companies today vs. 10, 20, and 30 years ago.

    Thanks for writing this

    1. Excellent point! Sarbanes Oxley has been a huge drag for small corporations.
      I don’t have hard data (anymore) but the number of small companies shrinking is most likely due to this effect!

  19. I think this is all fascinating but in the end I come back to trying to find alpha is the rabbit hole that draws so many to active managed funds and advisors.
    Retrospectively looking for patterns and drawing conclusions about future performance is right 50% of the time.
    Fund managers use this analysis to justify their expense but hopefully we all realize that is often luck or chance that is spun as skill or a model for success.

  20. First of all, many thanks for your fantastic blog! I look forward to every post.

    Regarding the 2% number, I am not familiar with Paul Merriman’s portfolio, but browsing around his website the first page I came across ( says: “But over nearly half a century those extra 2 percentage points (above the S&P 500) boosted the final portfolio value [,,,]”. The difference here is between the S&P500 and the author’s maximally diversified portfolio – not only SCV but also international, REITs and EM added – perhaps that is where the number came from.

    1. Thanks! I thought about that too. But again, international stocks and REITs don’t have an automatic stable boost in expected returns.
      Maybe EM, but that hasn’t materialized for so many years either. Certainly wouldn’t entice me to raise my expected return by 2%…

  21. Such a sector-unbiased value ETF does exist. See iShares Edge MSCI World Value Factor : the underlying index, MSCI World Enhanced Value, has this feature.

    1. Interesting! History starts only in 2013, so it’s not long enough to say with complete confidence what’s going on. Sadly, both the VLUE (US value fund, no sector bias) and IUSV (with sector bias) underperformed the ITOT since 2013. The VLUE not quite as much, but I would have expected better performance. So, maybe value was just bad since 2013, even within sectors. Bummer!
      But still, going forward, I think that the funds like the VLUE ETF might be something I could consider…
      THanks again for the pointer! 🙂

  22. There are other multi-asset index portfolios (on one website I notice it has a 0.60% exp. ratio) promising better performance with lower standard deviation risk than a 60/40 balanced passive index portfolio (Vanguard Balanced VBIAX has a 0.07% exp. ratio). And when you look at the 20-year 1999 – 2018 time period that the fancy multi-asset index portfolio proponent prominently displays on their website, it does slightly outperform the Vanguard Balanced 60/40 VBIAX, by almost 2% p.a. However when you look at the other shorter time periods they have on file not prominently displayed on their website, e.g. 3, 5, 10, 15 years, their fancy mutli-asset portfolio underperforms the 60/40 Vanguard VBIAX.

  23. With small caps being more volatile than the s&p 500 do you think dollar cost averaging would have any significant impact on one asset class return vs the other? On one hand you would buy more shares in a down swing but less in an up swing.

  24. Love your insight. Curious if your critique did the annual rebalancing of the “ultimate B&H strategy?” Also would like to know how the returns would be on an after tax basis assuming the money wasn’t in an IRA vs one that is? I could see that if rebalanced often, that taxes will hurt quoted returns. But he stresses that the goal is to sell winners to buy the “dogs” and wait for the cycle to repeat. I could see that happening again as it appears that cycles do repeat so we could find ourselves in a long lull where different classes perform differently than in the last 10,20 or 50 years.

    I met Paul at a small seminar a few months back in WI. He places the belief in the academics vs that of “wall street.” My understanding is he came out free of charge to do a couple of talks and flew back to WA, is “retired” from his financial practice and he didn’t have anything to sell (no books or anything). I found him to be genuine. He appears to want to give away his “knowledge” and keep investors from being fleeced by the industry he was in other than thinking people should talk with a pro once or twice to get some help (a consultation or a plan so to speak) without it being an ongoing syphon of your money.

    I don’t know if his approach is worth it or not but it is refreshing (like you, Big ERN) to find people willing to talk without charging us a percentage of AUM offering nothing but their experience and no sales pitch.

    I think what’s up is we’re hoping to get “DFA Funds” without having to go through an advisor that saps AUM fees (as well as the DFA fees).

    Many thanks.

    1. Good points!
      1: I did the regular rebalancing in my simulation.
      2: the tax issue is important. There is rebalancing both at the macro level (the styles have to be rebalanced) and the micro level (value stocks becoming growth and vice versa). It doesn’t sound like anyone takes that into account when they do the simulations. But it might be a further drag on returns.
      3: I agree that Paul isn’t selling anything and any (potentially bad) advice is not because he wants to fleece me. I should also say that I don’t believe what he does will do WORSE than plain index investing. I simply say, he’s wrong when he predicts 2% p.a. outperformance.
      4: academics vs. Wall Street: As someone who’s seen these two parts of the world, I can attest that Merriman is BSing. I can’t imagine anyone in academia (not even Fama and not even French) will agree with the 2% p.a. outperformance going forward.
      In fact, it’s the other way around: academics will more likely recommend index investing and “Wall Street” and advisers, etc. will recommend this convoluted stuff on small-cap-value etc.

  25. Maybe a naive question – Is a portfolio with equal sector allocation more diversified or one with sector allocation same as the market (market cap weighted index)?

    1. Not naive at all. Very good question!
      I’ve thought about the same thing. That portfolio is moving away from cap-weights, so in that sense it’s less diversified. But it’s also putting less weight on the very high-vol sectors (e.g. tech) and more weight on the boring/stable sectors (e.g. utilities). So it might have lower volatility and lower equity beta.

  26. What are your thoughts about the momentum factor ? The iShares Edge MSCI World Momentum Factor ETF looks very appealing to me. Thanks!

    1. Let me explain why.

      After having read (1) and (2), I tend to conclude that the only significant factor among large caps is momentum. Size and value might be valid factors only for microcaps one cannot access through a mainstream ETF (market cap under $500m for size, and $2B for value but better under $500m maybe).

      What is your opinion about that ?


      (1) : Israel, R., Moskowitz, T.J., The role of shorting, firm size, and time on market anomalies.
      (2) : Fama, E., French, K., Dissecting Anomalies

      1. That seems to be consistent with the academics right now. But even that is not written in stone. Who knows what kind of anomaly will work going forward.
        I like the “betting against beta” factor. There seems to be a fundamental rationale for this factor.

    2. Sounds interesting. But again, caution, because it’s a factor that’s very well-known in the industry and this is being used by many professional money managers.
      Also, caution about turnover! It will create a lot of taxable capital gains along the way. Not a good idea when holding in a taxable account!

    1. Time will tell if the SCV premium will work again.
      I don’t buy the argument that there’s not enough data. After so many years of underperformance we can pretty conclusively reject the hypothesis that there’s a 2% annual premium.
      I’m not saying that we have enough data to prove that SCV UNDERperferms, I simply say that 2% outperformance as claimed by Merriman seems ludicrous by now.

  27. Another great post, as I belatedly work my way through the entire SWR series! I’d love to have an update on this one, given the very different market we are in now. Thoughts on what the market plunge has done and will to SCV stocks now that the market has dropped the 30+% that you cited?

      1. Does that mean you are adjusting your stance. Would love an update on your thoughts!

        Amazing post by the way.

        Additionally, the PM UBH portfolio has a higher SD and feels a bit risky for those seeking FIRE due to the sequence of return risks (had trouble understanding why it would be popular in FIRE for that reason). Using portfoliovisualizer and portfolio charts I came across an allocation which seem to have a better (historical) ballast for FIRE to avoid the sequence of return risks while also having good historical returns. Also seems to have a higher SWR and PWR. It is heavily SCV and so may have the problems you discussed above but using a Monte Carlo and other references seen on portfoliocharts it seems to be better than a TSM index. It is 60% SCV (IJS) 25% LTB (TLT) and 15% GLD (IAU). Any thoughts on that would be appreciated.

        1. Still on the fence about SCV. It did perform as I suspected it would in the recession, i.e., SCV gets hammered worse. Not quite sure if that means it’s cheap enough already to jump in.

          Also, you have to compare apples-to-apples. 60%SCV, 25% LTB, 15% gold, did that outperform 60% Total Market, 25% LTB, 15% gold? Don’t compare your 60/25/15 portfolio to a 100% total stock market index, that would be an unfair comparison! 🙂

  28. Hi Big ERN. On this topic, I’ve just shared on a calculation you might find intriging. Hope to read you there.

  29. Alright, we had another bear market, and small value got crushed at it’s start! Ready to buy?

    1. Small and Value are still lagging behind. I’m glad I didn’t shift at the bottom.
      But it’s on my radar screen. Maybe tech will slow down now and the other sectors got some catching up to do…

    1. Yes, of course, the large+growth outperformance is nibbling away at the small+value advantage and the more data we get now the more statistically significant will be the structural break.
      Thanks for the link!

      1. Sometimes I wonder if the recent growth outperformance has a little to do with growing wealth inequality. It seems that super wealthy people that spend a very low percentage of their wealth each year, would be willing to pay a premium for assets that don’t throw off a lot of dividends and get most of their returns from capital gains which they can wait to realize when its most advantageous tax wise.

        Also, I think one of the reasons that value stocks may have been in more demand previously is that there used to be high transactions fees for selling stock so someone who was living on their investments would have preferred higher dividend value stocks as you usually didn’t have to pay fees on receiving the dividend.

        It seems like both of these reasons are why companies have been doing stock buy backs as opposed to issuing an addition dividend.

        1. Yeah, good points. Reminds me of the media hype recently about how rich people borrow against their portfolio as an estate planning tool. Much more tax efficient to defer gains until they die (and then they are tax-free due to the step-up basis).

          And yes, good point: higher dividend yield used to be much more attractive before the advent of online brokerages and and 0 commission trading! 🙂

          But also keep in mind a point I made before: value vs. growth is defined by the P/B ratio. Value stocks tend to have higher dividends, but there isn’t a 100% correlation!

  30. I would argue that events around interest rates in the last decade explains value’s underperformance much better than the discovery and wide spread knowledge of the the size and value factors. If you look at the macro economic events since 2008, one would expect growth to outperform value over that period. If rates continue to drop and the other macro trends continue, then we should expect growth continue to outperform. If we see a gradual increase of rates and inflation over the next decade along with other conditions which benefit value, then we should expect value to continue to outperform. Factors have always been streaky. Famously, the market factor failed to work for long periods of time; but there were macro explanations for why the factor underperformed during most of those periods. In addition, factor streakiness has historically lead to mean reversion. So at least historically, it has been best to buy SCV when it has done poorly, and best to sell it when it has done well over long periods. I’m not suggesting anyone does this (I do not myself outside of standard rebalancing). If one was going to redo their factor allocation, they would have wanted to buy SCV in 2000, sell it in 2010, and buy it in 2020. Although again, I would argue that the macro conditions do a *much* better job explaining performance. And I have no confidence in my own (or anyone else’s) ability to predict these trends with any reliability. As a result, I have no idea whether SCV will overperform or underperform over the next 10 years.

    Regardless, some people do share Paul’s belief that SCV will consistently outperform over a long enough period (say 30 years). Yet many (maybe most?) people who hold SCV do not expect it to outperform LCB by a large margin; perhaps enough to cover the added ERs over a period of 30 years or so on average, but not much more than that with any regularity, and within the range of the numbers you gave. They hold it for the same reason they hold EM and developed market stocks; diversification benefits. SCV has a relatively low correlation with LCB compared to most other US and developed (non EM) equity choices. After all, most people aren’t holding 100% of their US equities in SCV. They’re doing something like a 70/30 split of LCB/SCV.

    So what would cause me to drop SCV? If it became highly correlated with the corresponding LCB funds, and SCV became a mirror of the S&P500 with higher ERs.

    1. Not sure I follow this logic. What makes growth more susceptible to interest rates? I would have thought that brick and mortar companies should benefit more from low interest rates than growth companies?!

      Also, diversification is not a valid excuse. If you hold the total market index you already hold SCV. By shifting more into SCV you have less diversification.
      This is very different from EM. Your VTSAX does not include EM. EM stocks indeed could enhance diversification (to a degree). SCV reduces diversification. So, I don’t get this analogy. Or am I missing something?

  31. I’d like to see an update as this article was first published in 2019. Do you still hold the same views given where we are in 2022?

    1. It’s been a bumpy ride for the Fama-Frnech factors SMB and HML. They are up slightly, so since writing this article you might have benefited from this strategy. Not enough to declare total victory, though.
      I still consider the Small-Vap/value stuff a gimmick.

      1. Small cap value has had a temporary out performance in recent months. However if you zoom out to the nearly 3 years since this was written, the Vanguard Total Stock Market ETF still has still crushed the Vanguard Small Cap Value ETF (21.4% vs 16.5% CAGR).

      2. Appreciate the reply. The majority of my holdings are in VTWAX. I’m still on the fence about value or tilts. Since 2021 and early 2022 we’ve had a number of ETF’s drop onto the market that we’ve never had before:


        In addition to the ultra value ETF’s run by the likes of Wes Gray and Tobias Carlisle. All trying to be more “value” than the next one.

        Interesting times!

        I’m in my mid 40’s. I’ve been running 85/15 for the last 20 years. I’ve got rough 10k waiting. Do I go with a starting position into a DFA/Avantis fund or just VTWAX where the bulk of my positions already are, adding to the already built snowball? I just can’t decide where to allocate this next couple years worth of capital…

        (I just started the SWR series. Seems interesting so far, thanks for the great work.) (Is there anything in the SWR series that specifically touches on income generating portfolio(s)?)

        1. Income generating portfolios and why they don’t make sense: see parts 29,30,31

          I don’t give explicit asset allocation advice.. I’ve had the best luck with just a plain S&P 500 and US total market funds. Non-US stocks have had a long underperformance similar to the value tilt. I wonder if that reverts anytime soon.

  32. A few things…

    Small value might still be a really good idea for retirees. It only has really underperformed in the crashes of 2007, 2018, and 2020, but I think we can now be pretty safe in saying that those will not anything especially bad in terms of sequence risk in the US. Outside the US 2007 was really bad, but outside the US it seems that small value has slightly outperformed in that time period. Historically, small value has done great at protecting against the true worst US crashes that test the SWR – 1929, 1966, and 2000. It also did amazing in the worst developed stock market crash ever, the Japanese Lost Decades.

    As you mention, the valuation spread between small value and the S&P has grown, to nearly its highest level ever. The last time this happened was the 2000 bubble, and it very soon outperformed the S&P by 30% a year for 3 years in the ensuing bear market. If we have a repeat performance (and I suspect we will, I don’t see any systemic reason why valuations would work for predicting equity premium, but not factor premiums) you will sorely regret waiting for a crash to get into small value.

    In 1942, things were looking dire, both in the world and in the stock market. We were at this point clearly in another Great War, things look like they’re getting worse by the month, and US stocks had been trailing bonds since 1924, in fact they were only at equal performance looking all the way back 26 years (!) to 1916…at that point, can you still have faith in the equity risk premium? I would say the most important question in your post is the last question, and though I don’t really have an answer, I would almost certainly require stronger evidence against small value to give up on it than there was against equities in 1942. Of course we now see that the equity risk premium is very real, and 1942 was one of the worst years you could ever have chosen to give up on it.

    Finally, a relevant article:

    1. Thanks for the link. I like the idea that if something has been officially declared dead it might be a good time to invest again.
      Maybe with the tech meltdown (Nasdaq down >20%) we will see a revival of value over growth and small over big again.

  33. Very interesting article! Thank you!

    It sounds like you agree that an excess return of 50 basis points might be possible with a small cap value tilt. You rightly point out that harvesting this excess return comes with additional cost, but what about something like Vanguard’s small cap value ETF? The cost is only 7 basis points.

    For a long term investor, an excess return of 40 or 45 basis points could be meaningful, right?

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