Small-Cap Value Stocks: Diversification or Di-WORSE-fication?

December 2, 2024 – Many of you have asked me to comment on a recent phenomenon in the FI/FIRE community: Small-Cap Value (SCV) Stocks. Oh, my! Just when I thought we were making progress in the personal finance community, a new fad comes along and threatens to undo all that hard work. When you thought everyone was on board with simple, stress-free, and hands-off index investing, I sense that people feel the itch again to tinker with their portfolios – this time with “Small-Cap Value (SCV) Stocks.” To be precise, small-cap value is nothing new. I’ve written about my SCV skepticism in a post over five years ago. But the way it’s sold now is from a new angle, and it’s getting traction in the FI/FIRE community. The SCV media blitz relies on the latest narrative that, sure, broad index funds (VTI, ITOT, etc.) are a great and simple way to reach your financial goals. But SCV is an even better way—a “more optimal” way to reach your goals. Allegedly, SCV is the secret sauce for accelerated financial success for astute and enlightened investors.

But alas, much of that narrative is hype and false advertising. In today’s post, I want to reiterate the case for simple broad index investing. Let’s take a look…

Before we get started, though, I wanted to link a few recent podcast appearances. Please check out the following awesome podcasts and show them some SEO love:

• I chatted with Paula Pant on her Afford Anything podcast about the economic outlook, especially monetary policy. This episode is also on YouTube.
• My second appearance was on the Forget About Money Podcast, where I chatted about options trading.
• Finally, I appeared on the Catching Up to FI podcast to chat about my FIRE journey.

Now, back to today’s scheduled content…

Small-cap value stocks had an extraordinary performance until the early 2000s!

To give credit where credit is due, small-cap value stocks have had a fantastic run since 1926. A small-cap value fund would have significantly outperformed my go-to index, the S&P 500 (and its precursors), which I use for my Safe Withdrawal Rate research. Of course, to my knowledge, there were no low-cost SCV index funds before July 2000 when iShares launched its iShares Russell 2000 Value ETF (IWN). So, I need to rely on estimates for monthly returns for my backtest. To that end, I run a “factor model” to estimate IWM’s exposures to the S&P500 and the Fama-French SML (small minus large-cap) and HML (high minus low book/value ratio, i.e., value over growth) factors and then construct the estimated IWM monthly returns between 1926 and 2000. In my regressions, I found that the IWN ETF behaved like a portfolio with 99% S&P 500, 1% cash (i.e., 3M Treasury Bills), 95% Fama-French SMB factor, and 52% Fama-French HML factor. I also subtract a 0.24% per annum expense ratio from the estimates. To replicate the S&P 500 ETF, I use a 100% S&P index portfolio minus 0.03% annually to account for the IVV expense ratio.

In the chart below, I plot the cumulative real (CPI-adjusted) returns since June 1926. I also include the SCV outperformance vs. the S&P 500. I normalized all figures to 1.0 on June 30, 1926, and plotted this with a log scale on the y-axis to better display the exponential growth over time. No doubt, SCV had a great run over the last 98 years. It outperformed the S&P 500 index by about 2.6 percentage points annually. The final value of the SCV portfolio is about 10x the S&P 500’s.

So, it’s no surprise that SCV has won many fans in the personal finance community. Some of the proponents are Paul Merriman and several other SCV fanboys (and girls) on the interwebs, including the Risk Parity crowd; Frank Vasquez uses SCV in some of the sample portfolios at Risk Parity Radio.

A previous version of the post also attributed the recent SCV-mania to Joe Saul-Sehy (Stacking Benjamins) on a recent Afford Anything podcast (at about the 9:30 mark). However, in a comment below, Joe made clear that he’s not an SCV fanboy. Rather, he prefers a more nuanced approach to portfolio construction through the Efficient Frontier; see a recent Afford Anything episode for more info. With this approach, you may find portfolios not as simple as they are often recommended in the FIRE community.

The 4-Fund Portfolio

But let me focus on the SCV main character, Paul Merriman. His new en vogue portfolio is the 4-fund portfolio (4FP), comprised of equal 25% shares of the S&P 500, large-cap value, small-cap blend, and small-cap value. A few years ago, it was a 10-fund portfolio. I couldn’t ascertain why the preferred SCV portfolio changes over time. I’ve been around in the finance world long enough to suspect that when someone’s “Forever Portfolio” changes every five years, it’s likely due to overfitting and backward-looking bias.

In any case, I simulated the returns of a portfolio comprised of the corresponding iShares ETFs: IVV for the large-cap blend, IWD for large-cap value, IWM for the Small-Cap Blend, and, as before, IWN for the Small-Cap Value. ETF returns, the simulated returns, and the factor exposures I estimated for the funds are in the table below. I also subtract the respective expense ratios to arrive at my estimated ETF returns pre-2000: 0.03% p.a. for IVV, 0.19% p.a. for IWD and IWM, and 0.24% p.a. for IWM.

We first notice that the most recent ETF performance of all the non-IVV funds stinks. Very consistently, over all horizons from one year to twenty years, the exotic ETFs underperform the plain old IVV ETF, and often significantly. The same is true for the four funds mixed with equal weights. My simulated returns align very well with the ones Paul Merriman found. Specifically, I confirmed that during the 1928-2021 period, the 4F portfolio outperformed the IVV by 1.7 percentage points (11.7% vs. 10.0%) in my simulations, the same outperformance as Merriman found over the same horizon.

But let me first plot the same chart for the 4-Fund portfolio; please see below. If you’ve seen Paul Merriman’s presentations, say, in Paula’s podcast at around the 4:12 mark, they resemble each other remarkably well. However, note the slightly different start and end points, especially that Paul Merriman “conveniently” ignores the post-2020 underperformance.

So, what’s not to like about SCV and the 4-Fund portfolio, then? The pretty chart above insinuates that the 4F portfolio consistently outperformed the S&P, right? The orange line has been above the green one since at least the 1930s, so you would have always done better during that period, right? All the cohorts beat the S&P 500 by 4x, right? Wrong! What the chart disguises is the recent underperformance of the 4FP. The orange line may have been above the green, but the distance has narrowed noticeably. That’s also reflected in the black line, i.e., the 4FP divided by the S&P 500 falling. Of course, we already knew that by looking at the recent ETF performance data in the table above. This brings me to the next point…

Small-cap value stocks have underperformed recently!

What I found very sneaky about long-term cumulative return charts like the ones Paul Merrmiman tours around with is that they have very little relevance for investors alive today. Notably, I know nobody who has been investing in the 4FP since 1926. Every point along the chart above corresponds to a cohort that initiated a buy-and-hold investment in 1926. For example, if I go along the horizontal axis and look up the values for 1980, the lines indicate the performance from 1926 to 1980. How many investors like that do you know?

A vastly more informative chart would be to ask, among all the different investors alive today, how well would they have done with the 4FP relative to the S&P 500, depending on when they started investing? So, let me do that in the chart below. On the horizontal axis, I plot the buy-and-hold investing period’s starting month rather than the ending date. Of course, by definition, the function values at 6/1926 in this new chart coincide with those at 10/2024 in the Merriman-style chart above.

The central insight I gather from this chart is that since the late 1990s, no buy-and-hold investor would have beaten the S&P 500 with a 4-Fund Portfolio. Even for investors between 1982 and 1999, the two portfolios were about even, visible by the black line closely hugging the 1.00 value. Finally, only pre-1982 4FP investors have consistently outperformed the large-cap index. So, absolutely nobody alive today would have done four times better than the S&P 500 index with this 4-fund portfolio, in stark contrast to the false advertising you heard from SCV fans in their recent podcast media blitz.

So, is it only me who’s defending the honor of simple index investing? Not entirely; I should give kudos to Rick Ferri for a good presentation, “The Case Against Factor Investing,” at the 2023 Bogleheads conference (his excellent slides are on pages 141-151 in the pdf). At the 2024 Bogleheads conference, one segment featured Paul Merriman with Dr. James Dahle (White Coat Investor) moderating and providing some skepticism and pushback. But I’m still shocked that so many other usually enlightened FI/FIRE influencers cast aside their passive investing principles and were intrigued by this SCV/4FP mumbo-jumbo. Most disappointingly, in a recent Forget About Money podcast, JL Collins seems to endorse SCV.

Is the Small-Cap Value Stock out-/underperformance statistically significant?

Another fly in the ointment for the SCV crowd is that despite all the pretty charts and tables that Paul Merriman posts on his site, he fails to answer one central question: is any of the 4FP outperformance even statically significant? If so, at what level? So, let me do that for you. Of course, there isn’t one single way to determine that, so I will present three different ways:

1: Statistical Significance over the entire 1926-2024 time period

First, I calculate the monthly outperformance of the 4-Fund portfolio over the S&P 500. The average monthly outperformance of the 4-Fund portfolio was just about 0.10%. The monthly standard deviation was 1.85%, and the sample size was 1,180.

Technical note for the Math Geeks: We cannot use r_4FP-r_SPX or even (1+r_4FP)/(1+r_SPX)-1 for this exercise because averages of those times series will usually not coincide with the average outperformance due to compounding effects. To account for compounding, we must use (natural) logarithmic returns, i.e., ln[(1+r_4FP)/(1+r_SPX)] as our time series.

To test whether the mean outperformance significantly differs from zero, I compute a t-statistic of 1.90. That’s quite impressive, but you still can’t reject the Null Hypotheses of a zero mean at alpha=5% significance. That critical value would have been 1.96. So, the SCV crowd sells me a story that’s only slightly less than statistically significant, even under the best circumstances, i.e., including all the outperformance from “way back when” and the smell of “hindsight bias” of regularly changing the portfolio weights of the “forever” portfolio.

And it only gets worse from here…

2: Rolling 10-year windows

I also like to see how consistent (or not!) this 4-Fund portfolio outperformance vis-a-vis the S&P 500 has been over shorter horizons, i.e., over the average complete economic and stock market cycle. Ten years would be a long enough estimate for capturing at least one recession and expansion. And one bull market and one bear market. So, let’s plot 120-month rolling t-stats for the Null Hypothesis that the mean outperformance is zero. I also include the +/-1.96 critical value bands to indicate where we can find significant outperformance (or underperformance). Sadly, there are only a few 10-year windows when this outperformance is actually significant.

So, can you increase your safe withdrawal with SCV/4FP? Due to Sequence Risk, the first market cycle determines much of your retirement success. But if the outperformance isn’t consistent enough to prevail over every single market cycle, I would not pin my hopes on SCV/4FP increasing my safe spending rate if the outperformance is so elusive and unreliable and may only benefit my portfolio too late into my retirement.

Of course, the good news for the SCV/4FP fans is that the recent underperformance isn’t statistically significant either. So, for the SCV skeptics, don’t feel overly confident either! Specifically, don’t replace your broad market index with just large-cap growth.

3: (Backward-)Expanding time windows, ending in 2024

Finally, I do the same exercise as before, i.e., expand the time intervals backward with the same endpoint in 2024. In other words, I want to determine which cohorts with a starting point between 6/1926 and 10/2014 and a common endpoint in 10/2024 would have experienced statistically significant outperformance when investing using the 4-Fund method.

I plot the t-stats in the chart below. The good news for SCV is that, as bad as its recent returns have been, they have never been significantly different from the S&P 500, at least not at a 5% significance level. But that’s where good news ends. Even for cohorts in the 1990s, the occasional slight outperformance of 4FP over the S&P 500 is essentially statistical noise. The t-stat never even reaches +0.5. Even well before 1982, the 4FP outperformance is far from statistically significant. To reach statistical significance, we’d have to find a buy-and-hold investor who’s been in the market since 1943, i.e., for 80+ years! As pointed out before, if we move back to 6/1926, we drop just slightly below the significance threshold again to 1.90.

Side note: Of course, we could also run one-sided tests. In that case, the 5% critical values would have been about -1.645 and +1.645, respectively. The most recent data would have supported rejecting the Null Hypothesis of SCV weakly outperforming the S&P 500.

Small-cap value stocks look even worse with regular investments!

In the calculations above, I studied buy-and-hold investors. We can also ask ourselves whether any investors alive today who made regular contributions along the way would have benefited from this 4F portfolio. That is even more relevant for those investors who built their nest egg over time, like most of us in the FI/FIRE community.

So, how early would a 4FP investor with regular contributions have to start investing to outperform a simple S&P 500 portfolio? I plot that information in the chart below. Specifically, for every cohort on the horizontal axis, I plot the portfolio value this cohort would have accumulated up to 10/2024 when saving $1 monthly. As always, all returns and contributions are CPI-adjusted.

The crossover point where an investor with regular monthly contributions would have done better with the 4F portfolio was in March 1977. To get a sizable boost, say 2x vis-a-vis a simple S&P500 portfolio, you’d have to move back to regular investing since 1943. Even with regular contributions since 1926, almost 100 years long, you’d stay slightly below 3x the S&P 500 portfolio. Thus, very few SCV fans alive today are richer than their S&P 500 counterparts. All the claims that you can miraculously 4x your portfolio with this simple SCV trick are false advertising.

Why is the crossover point even worse than for the buy-and-hold investors? It’s due to one of my favorite finance subjects, i.e., Sequence Risk; you benefited relatively little from the SCV outperformance before its peak when your portfolio was (relatively) small during the first few decades of your accumulation period. And then, when you had a much larger portfolio later in the accumulation phase, you got slammed with the terrible underperformance of SCV vs. the S&P 500.

Diversification or Di-WORSE-fication?

If the average returns of SCV don’t look too appetizing, especially in the last 40 years, another angle folks try to sell SCV and 4FP is that they offer better diversification. Specifically, most SCV fans claim that your average total market index funds (e.g., Vanguard’s VTI, iShares ITOT, etc.) and certainly your large-cap index funds (Vanguard’s VOO, State Street’s SPY, iShares IVV, etc.) are “not diversified enough,” and adding SCV lowers your risk (their words, not mine). That would be a desirable feature, especially in retirement when you like to avoid steep drawdowns and Sequence Risk.

But alas, the volatility reduction claim is demonstrably false on at least two levels. First, a total market fund is diversified by definition because it includes all the large-cap and small-cap stocks plus value and growth stocks. All constituents are weighted according to their market cap (often adjusted for “free float” only, i.e., excluding restricted/closely held shares). So, adding more small-cap value will cause less diversification and more concentration.

Second, in most cases, the diversification claim is also purely statistically false. Adding new assets to a portfolio can indeed increase your portfolio’s standard deviation, even if those new assets have correlations substantially below 1.00. A necessary condition for a new asset to reduce the overall portfolio volatility is that its standard deviation times the correlation between the asset and the current portfolio is less than the current portfolio’s standard deviation. For the Math wonks, here is my short derivation of this basic finance/statistics fact:

So, let’s put that formula to work. Let’s calculate the volatilities and correlations of the alternative ETFs and the Merriman 4-Fund portfolio to see which would help diversify equity risk. Notice that all exotic ETFs had volatilities greater than the IVV S&P 500 ETF. But IWD has indeed a correlation small enough to bring the sigma times rho below that of the IVV. So, a large-cap value ETF like IWD would have, at the margin, slightly reduced your volatility. However, the other ETFs and the Merriman-Style 4-Fund portfolio would not diversify your portfolio. Instead, they would di-WORSE-fy your portfolio by increasing your volatility. It’s a mathematical certainty. I also confirmed that the same is true over different horizons (i.e., over 20 years, since the ETF inceptions in 2000, and even when extending the series back to the simulated period starting in 1926).

Side note 1: By the way, the same result also holds if adding only the three funds IWD+IWM+IWN, instead of the four funds together.

Side note 2: Even a total market index, i.e., the iShares ITOT or the Vanguard VTI/VTSAX, would routinely fail this criterion. Example 10/2014-10/2024: VTI risk = 15.63% p.a., correlation w/ SPX=0.9953. 15.63%*0.9953=15.55%, which exceeds the S&P 500 risk of 15.2%. So, intriguingly, going from 500 stocks to 3,600+ tickers in the VTI does not lower your risk!

Side note 3: This is solely about volatility. Despite the slight vol reduction after including in US Large-Cap Value stocks, you still would have reduced the Sharpe Ratio!

To be clear, Paul Merriman has gone back and forth on this volatility issue. Sometimes, he concedes that the 4-Fund portfolio has higher risk; please see the return stats table screenshot from his site:

However, in a recent Afford Anything podcast (around the 4:15 mark), he contradicted himself and claimed that the 4-Fund portfolio had lower volatility.

So, I recommend that my readers avoid the 4-Factor portfolio and other variations of SCV. It would have made people’s portfolios WORSE over the last few decades. Thus, it’s been true Di-WORSE-fication, not just from an average return perspective but also from a diversification and risk minimization point of view.

Can this poor performance turn around?

I don’t want to sound too pessimistic about Small-Cap Value. As I indicated above, the statistical evidence for the S&P 500 outperforming SCV/4FP is also weak. There is also the risk that all the artificial intelligence (AI) optimism was for naught and all that large-cap growth outperformance comes to a crushing end. It’s certainly possible, but it’s hard to know if this reversal ever happens. And it’s even more difficult to time the exact turning point. I don’t want to take a side in the pro vs. cons AI fight, so with a broad index fund, I cover both scenarios: growth and value.

Conclusion

My regular readers know that I am in no way beholden to the passive indexing & simple investing crowd. Quite the opposite, from 2008 until 2018, my paycheck came from working in (gasp!) active, global tactical asset allocation (GTAA) at Bank of New York Mellon Asset Management. In retirement, I generate extra income trading options. My Safe Withdrawal Rate Series is about how personal finance isn’t as simple as often proclaimed in other corners of the FIRE movement. If there are ways to improve your financial success and optimize your portfolio, I’ll be eager to check them out with an open mind. I’d want them to work and will proudly announce the news here on my blog. I am currently doing so for my options strategy. But SCV and its derivatives like the 4FP aren’t that new secret sauce. The incremental performance of SCV and the 4-Fund portfolio above the S&P 500 is too volatile to pin your hopes on this “flavor of the month.” But for the record, I’m not forecasting that the SCV/4FP’s recent underperformance will continue. So, don’t go 100% large-cap growth, either. I recommend keeping it simple and using a broadly diversified equity index fund. A total market fund (FZROX, ITOT, VTI, VTSAX) works, though I slightly prefer large-cap funds like FNILX, IVV, VOO, etc. Happy Investing!

Thanks for stopping by today! I look forward to your comments and suggestions!

Title Picture: AI-generated with WordPress