Quote from earlyretirementnow.com on June 1, 2025, 10:04 am

June 2, 2025 - Welcome to another installment in my Safe Withdrawal Series, please check the landing page for all posts so far. Today's topic is about Small-Cap Value (SCV) stocks and whether they should have a prominent role in retirement portfolios. Some financial experts recommend adding Small-Cap Value to your retirement portfolio, which will miraculously and automatically increase your safe withdrawal rate from 4$ to 5% or even 5.5%.

Of course, if you are familiar with my blog, you will know that I am skeptical of SCV. I've written two posts, one in 2019 and one last year, where I outline my main concern: the Small-Cap Value engine that generated extra returns worth several percentage points between 1926 and about 2005 started sputtering about twenty years ago. I don't see the party picking up again anytime soon. So, in today's post, I like to show some simulations using historical data to showcase how you could have indeed outperfomred using SCV stocks. But I also want to give those folks who are skeptical about the potential of the SCV outperformance of the 1930s to 1980s to repeat again

Let's take a look...

Small-Cap Value in Safe Withdrawal Rate Simulations

In my Google Sheet, I provided a large selection of asset returns, including the Fama-French SMB and HML factors. Let's put these series to work and simulate how a Small-Cap Value portfolio would have performed over time.

Let's start with the simple baseline case safe withdrawal scenario without any Small-Cap Value stocks:

• A 30-year horizon.
• 0% final asset value target, i.e., asset depletion.
• 75% large-cap stocks, 25% intermediate government bonds (10-year benchmark bonds)
• A 0.05% weighted expense ratio.

Next, let's assume our investor added Small-Cap Value stocks to diversify the equity portfolio. Specifically, assume we replace one-half of the equity portfolio with SCV. To simulate this in my toolkit, I assume that we keep the 75% equity allocation but replace half of the S&P 500 index fund with SCV. You might be tempted to set both Fama French SMB and HML factors to 37.5%. However, most SCV funds I am aware of don't achieve full 100% exposure to those factors. In my Google Sheet, I provide factor regression slope estimates for a wide range of ETFs, mutual funds and (see tab "ETF Factor Exposures")

Most of the SCV ETFs and Mutual Funds have SMB exposures of around 90% and HML exposure of around 60-70%.

So, let's assume that our SCV equity fund has an SMB exposure of 90% and an HML exposure of 70%. I then assign 0.9x0.375=0.3375=33.75% exposure to SMB and 0.7x0.375=0.2625=26.25%.

To account for the slightly higher management fees in your average SCV fund (e.g., 0.31% p.a. in the DFSVX) I also apply a 0.20% p.a. additional management fee to the SCV portion only. So, for example, if the baseline portfolio has a 0.05% weighted expense ratio, I assume that the 37.5% move to SCV necessitates an additional 0.375x0.20%=0.075% p.a. Thus, the weighted expense ratio is now 0.05% + 0.075% = 0.125%.

Now, let's examine the simulation results and compare the worst-case withdrawal rates by decade; please refer to the table below. If we ignore the safe withdrawal rates in the earlier decades (the 1900s and 1910s), where the SMB and HML returns were not available (i.e., set to zero for most of the retirement horizon), there is a universal improvement in the failsafe withdrawal rates in every single decade. That's impressive! The 1920s failsafe at the pre-Great-Depression market peak is more than a whole percentage point higher (4.98% vs. 3.84%). The worst-case scenario for the SCV portfolio is in the 1960s: as usual, the December 1968 cohort. However, even in that cohort, we can achieve an impressive 4.46% withdrawal rate and never run out of money during a 30-year retirement.

So, what's not to like about SCV then? Should I now shift half of my equity portfolio over to an SCV ETF and sail into the sunset? Not so fast. Here is a cumulative return chart of the two Fama-French factors since 1926; please refer to the chart and table below.

SMB (the small-cap factor) had only two major return boosters: one in the 1930s and 1940s and the other in the 1970s. Since the early 1980s, approximately 45 years ago, small-cap stocks have not consistently outperformed large-cap stocks. According to market historians, the second boost likely came from institutional investors rushing into small-cap stocks, a sector they had previously avoided. I suspect that the first boost in the 1930s and 1940s is also a response to the market shock in the 1920s and 30s, and investor participation, i.e., retail investors who were burned by the Great Depression rushing into the market again and picking up the pieces, and especially beaten down small-cap stocks after the big drop.

Absent any new stark market and investor preference changes that make small-cap stocks more attractive and mainstream again, I don't see any sizable return advantage. If anything, small-cap stocks are now widely traded, and there is great ETF and mutual fund coverage. Where is that new rush into small-cap stocks going to come from?

HML (the value factor) had a very impressive run from 1926 to approximately 2006. During that time, we observed frequent drawdowns, typically coinciding with recessions and bear markets; however, the subsequent recovery consistently pushed the HML factor to new highs. However, it's as if someone flipped a switch in 2006, and the red line is now trending downward. If you're a chartist, you'd hate the HML chart: since 2006, you got successively lower lows and lower highs.

I should stress that I'm not saying that this recent 20-year HML and SMB dumpster fire will continue forever. I invest in broad-market index funds that cover both growth and value stocks, as well as large and small-cap stocks, because I believe in efficient markets. There is no free lunch, neither on the growth nor the value side of the market. Any "alpha," i.e., free and reliable outperformance, will likely be arbitraged away by investors who are much smarter and faster-moving than some finance blogger in his home office in Washington State. The "alphas" we've observed historically, like 5%+ for HML between 1926 and 2006 and the 3.35% in SMB from 1926 to 1979 are no more!

So, how can we account for the likely regime shift in SMB and HML returns in my SWR toolkit? That brings me to the next section...

How to model a more "realistic" Small-Cap Value premium

Imagine you are a retiree today who subscribes to the idea that the 1926-2006 performance in SCV was an anomaly. But you still like to use my toolkit, including the SMB and HML factors. How can we "clean up the SMB and HML factor returns? Specifically, we want to achieve two tasks: 1) maintain the salient features of the SMB and HML factors, i.e., correlations with the business cycle and other asset classes, but 2) remove the likely ill-gotten average excess returns that we will likely not replicate going forward. And, of course, I'm not saying that absolutely zero excess return must prevail. We can always add back a "reasonable" alpha to those SMB and HML factors. Not as high as historically, but at least assign realistic and definsible outperformance of the SMB and HML factors.

To achieve the first task, I apply the Hodrick-Prescott Filter (HP-Filter) to separate the trend from the cycle of both the SMB and HML series. The HP-Filer was developed by Robert J Hodrick and Nobel Laureate Edward C. Prescott (who taught me macroeconomics at the University of Minnesota) and was developed exactly for this task, i.e., to separate economic cycle from trend in time series.

I plot the results in the two charts below. The black line is the cumulative Fama-French Factor return, the green line is the HP-Filter trend and the red line is the

And I do the same with the HML factor.

There is an additional adjustment I performed to clean the return data a bit further. The monthly HP-filtered SMB and HML returns could still have a slightly non-zero mean. To fix that, I added one more adjustment to ensure that the following three portfolios all have the same Compound Annual Growth Rate (CAGR) over the period with available SMB/HML data, i.e., 7/1926-3/2025: 100% S&P 500, 100% S&P 500 + 100% SMB, and 100% S&P 500 + 100% SMB. To confirm that, please see below:

Next, I simulate the SMB and HML factors without any additional excess returns. To do so, I keep the SMB and HML weights at 33.75% and 26.25%, respectively, but change the Data Series to "HP-Filtered." I also keep the additional alpha for those factors at 0% for now. Furthermore, I set the expense ratio to 0.125%.

And here are the results, all compared to the plain and simple 75/25 benchmark. Not surprisingly, your safe withdrawal rates stink when using zero-alpha SMB and HML factors. Especially during the historical worst-case scenarios (1929 and 1968), you would have further lowered the already low withdrawal rates. Of course, and notably, even a zero average factor return could have greatly benefited your retirement, say, in the 1980s and 1990s, because HML hedged the 2001-2003 bear market quite nicely. Specifically, HML dropped precipitously before the market peak and then recovered during the bear market. So, I'm not bashing HML. There were a few historical retirement cohorts that may have benefited from this style

Of course, our next step should be to assign some "reasonable" SMB and HML factor outperformance to see how much traction we get from SCV in our SWR simulations. This brings us to the next section...

What's a "realistic" Small-Cap Value alpha going forward?

Vanguard's asset class return expectations model indeed anticipates a marked outperformance of some of the equity flavors. For example, Vanguard believes that small-cap stocks will outperform large-cap stocks by 120 basis points over the next 30 years. Also, U.S. value is expected to outperform growth by 160 bps so that one would use half that or 0.80% as the outperformance of value stocks over a blended (i.e., half value + half growth) index.

So, I apply the 1.20% and 0.80% annualized alpha to the HP-Filtered returns; please see how I implemented that in my Google Sheet.

And here are the results; please see the table below. Several decades saw an improvement in your SWR, but only those that already had no major Sequence Risk issues. But the 1920s and 1960 saw very little movement. In the 1960s you even managed to lose 2 bps in your SWR.

How about a longer horizon?

Let's repeat the same exercise with a 50-year horizon. All other parameters are the same, including the 0% final asset target. I simply changed the horizon to 600 months. Qualitatively, we obtain very similar results, although all SWRs are shifted down by approximately 30-50 bps due to the longer horizon.

• Using historical returns for the 37.5% SCV portion, you shift up the failsafe in every single decade. Though, I would not recommend a 5% and certainly not a 5.5%. The 1920s and 1930s remain solidly below 5% SWR. The 1960s failsafe (December 1968, but also several more cohorts from 1964/65) would have done even worse with a 4.16% failsafe.
• Using the zero-alpha, HP-filtered SMB/HML returns, you reduce your SWR by about 12 bps (3.27% vs. 3.39) in the post-1926 era.
• But with the calibrated extra returns in SMB and HML, you brighten the picture a bit. The post-1926 SWR rises by 12 bps (3.51% vs. 3.39%).

So, what do I make of this? If you believe that going forward, both HML and SMB will fetch a modest extra return over the boring large-cap blend index, I don't fault you for tipping your toes into the Small-Cap Value pond. But don't expect miracles. The increase in your SWR is about half of what you'd expect from a reverse glidepath (see Parts 19 and 20).

A different Small-Cap Value strategy: Golden Butterfly

People come up with new asset allocation schemes faster than I can simulate them. One asset allocation style that's become very popular is the so-called Golden Butterfly, which adds gold, long-term bonds, and small-cap value stocks to the mix. Specifically, the Golden Butterfly portfolio has five equal 20% shares of 1) large-cap blend stocks (e.g., S&P 500), 2) small-cap value stocks, 3) long-term government (e.g., 30-year) bonds, 4) short-term government bond (e.g., 3-moth T-bills), and 5) gold. As before, I like to start with the good old and simple 75/25 portfolio and then go through the progression of four different Golden Butterfly-style portfolios:

1. Start without the Small-Cap Value, but use a 40% large-cap blend initially, along with 20% long-term bonds, 20% short-term bonds, and 20% gold. (Call that Golden Butterfly Light)
2. Replace 20 percentage points of the S&P 500 with Small-Cap Value stocks and use the historical returns for SMB and HML.
3. Instead of the historical SMB and HML returns, use the zero-alpha SMB and HML factors.
4. Add the 1.2% annualized alpha to SMB and 0.8% annualized alpha to HML.

Please see the simulation results below. The safe withdrawal rates are pretty disappointing. You can tell that this strategy was maximized to make the 1970s look as pretty as possible. Why 1970? It's because the inventor of that rule has monthly simulation data only going back to 1970, thus missing the true historical worst-case scenrios. But in exchange for better results during 1970-2025, you get worse results elsewhere. It's like squeezing a balloon. Let's go through the different portfolio's withdrawal rate stats:

• The Golden Butterfly without SCV (Golden Butterfly Light) would do slightly better in 1929 and even in 1968. However, the 1930s and 1940s, decades that posed little to no headache with the 75/25 baseline portfolio, now look awful. The post-1926 failsafe was only 2.80%, much lower than the 3.39% in the baseline. It's a 17.4% lower retirement buget.
• The standard Golden Butterfly with SCV and using actual historical SMB/HML returns does much better than the Butterfly Light, but still manages to underperform terribly in the 1930s and 1940s. Yes, you get an absolutely amazing 5.22% SWR in the 1970, even for a 50-year horizon. That's what data-snooping, in-sample bias, and hindsight bias look like. But it comes at a cost much lower sustainable withdrawal rates in other decades and other market conditions.
• Results only get worse from here. For example, when the Fama-French Factors have zero alpha, the 1930s and 1940s are now the new worst-case historical cohorts. The overall failsafe is only 2.70%, much lower than what the 75/25 would generate.
• And even assigning the Vanguard-approved factor alphas, you still can't manage to bringthe overall failsafe above 3%.

The punchline here: The Golden Butterfly portfolio was optimized specifically with the 1970s, especially the December 1972 cohort, in mind.

Conclusion

Will small-cap value stock miraculously increase my safe withdrawal rate to 5% or even 5.5%? If I add the historical and unadjusted SMB and HML factor returns to my portfolio, i.e., I believe that the historical outperformance will repeat, I can certainly make that case. But I'm doubtful. I don't even have to assume that the poor returns of SCV of the last twenty years need to continue. If I merely assume that small-cap stocks and value stocks add zero extra alpha going forward, then safe withdrawal rates will look worse because we add more equity volatility with little extra return, which is bad from a Sequence Risk perspective. I called that "Di-Worse-fication" in my post last year.

However, admittedly, shifting about half of your 75% equity allocation into small-cap value might work if the Vanguard expected return projections materialize as planned. If that's your thing, I wish you good luck, but I would not take that chance. I would also not recommend raising the withdrawal rate by much more than a few basis points. Don't go to 5%, and certainly not 5.5%.

I also issue a stern warning about any exotic and overfitted portfolio allocations that were optimized to make only(!) the 1970-2020 interval appear favorable, such as the Golden Butterfly portfolio. A repeat of some of the other recessions and bear market scenarios, such as the 1920s and 1930s, would blow up your retirement with a withdrawal rate of more than 4%. Therefore, my recommendation remains the same: Don't listen to the noise and hype. Instead, keep your retirement portfolio simple. 75/25 is a great starting point. Customize your withdrawal rate to account for your unique parameters, such as future pension and Social Security benefits. Monitor market valuations, i.e., scale back withdrawal rates in light of expensive CAPE ratios. You should have a relaxed and safe retirement.

Please leave your comments and suggestions below! Also, check out the other parts of the series; see here for a guide to the different parts so far!

Title Picture Credit: WordPress AI