Quote from earlyretirementnow.com on May 31, 2025, 3:54 pm

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

So, in today's post I like to show some simulations using historical data to showcase how you could have indeed

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 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's a cumulative return chart of the two Fama-French factors since 1926; please see below.

SMB (the small-cap factor) had only two major return boosters, one in the 1930s/40s and the other in the 1970s. Since the early 1980s, i.e., for about 45 years now, small-cap stocks did not produce sustained outperformance vis-a-vis 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. Probably the first boost in the 1930s and 1940s is also a response to the great market shock in the 1920s and 30s, and investor participation.

Absent any new stark market and investor preference changes that make small-cap stocks more mainstream, I don't see any marked 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 HML dumpster fire will continue forever. I invest in broad-market index funds that include both growth and value stocks, as 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 finaince blogger in his home office in Washington State. Especially

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 and not throw out the baby with the bathwater, i.e., never use the Fama-French factors at all. 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 from

So,

And I do the same with the HML factor.

There is an additional

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

So, I apply the 1.20% and 0.80% annualized alpha to the HP-Filtered

What would a retiree today do to simulate

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,

A different Small-Cap Value strategy: Golden Butterfly

People come up with new asset allocation schemes faster than I can simulate

Conclusion

Will small-cap value stock miraculously increase my safe withdrawal rate to 5% or even 5.5%? If you add the historical and unadjusted SMB and HML factor returns to my portfolio, i.e., you believe that the historical outperformance will repeat, you 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 we merely assume that small-cap stocks and value stocks add zero extra alpha going forward then safe withdrawal will likely look worse because you add more equity volatility with little extra return, which isbad from a Sequence Risk perspective. But admittedly, shifting about half of your 75% equity allocation into small-cap value might work if the Vanguard expected return projections work out 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. Don't go to 5%, and certainly not 5.5%.

I also issue a stern warning about any overfitted portfolio allocations that were optimized to make only the 1970-2020 interval appear favorable, such as Golden Butterfly and likely others. A repeat of some of the other recessions and bear market scenarios, like the 1920s and 30s, would blow up your retirement.

Therefore, my recommendation remains the same: keep your retirement portfolio simple.

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!

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