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Many investors divide the U.S. equity market (SPY) into smaller pieces, hoping to identify the types of stocks that will outperform the market over the long run. Although there are hundreds of ways to slice and dice the broader equity market, three of the most common sub-classes of stocks that attract investor attention are value stocks, small caps and REITs. I can understand the appeal of all three, and have considered over-weighting them in my own portfolio. The problem is that if everyone loves them, the prices of these stocks will be bid up and their outperformance or diversification benefits will disappear.

In this article, I argue that this is exactly what has happened. At current valuations relative to the market, there is little reason to expect future outperformance from small caps, REITs, or value stocks as a whole. In the sections below, I describe first how these three flavors of equities became popular, and second why their future prospects do not look as bright as the past.

3-Factor Model

In their groundbreaking research, academics Eugene Fama and Kenneth French identified three factors that appeared to shape historical stock returns: overall market risk (beta), size, and value. What was especially interesting in their paper was the finding that small caps and low p/b stocks outperformed over time. From the time that the study was first published in the early 1990s, this breakthrough eventually trickled down through the ranks of investment professionals and has become widely known. Particularly after the collapse of the tech bubble with its large cap growth bias, small caps and value stocks have been on a roll. ETF providers have stepped in to meet this demand for investment vehicles that focus on value stocks or small caps, such as the iShares Russell 1000 Value Index ETF (IWD) and the iShares Russell 2000 Index ETF (IWM). Or, if you really want to get fancy, there are combo funds like the Vanguard Small Cap Value ETF (VBR).

REITs as an Asset Class

REITs have a lot to commend them, including high yields, tax advantages and modest diversification properties vis-à-vis other equities. In his popular book Unconventional Success: A Fundamental Approach to Personal Investment, Yale endowment manager David Swensen makes the case for a special allocation to real estate in individual portfolios. For many investors, this has meant including a tilt towards REIT funds such as the Vanguard REIT ETF (VNQ). Mr. Swensen's impressive investment record and the extended low-yield environment have convinced many income-oriented and total return folks alike to devote a portion of their portfolios specifically to REITs.

Past Performance and Future Prospects

Part of the popularity of REITs, small caps and value stocks is that they have all done quite well in the last decade relative to the overall market. But as seasoned investors know, outperformance in one period often means underperformance in the next.

To assess the historical relative valuation of small caps, value stocks and REITs versus the overall market, I divided the Wilshire Large Cap Value Total Market Index, Wilshire Small Cap Total Market Index, Wilshire Micro Cap Total Market Index, and Wilshire Real Estate Investment Trust Index by the Wilshire 5000 total market index. Each of these indices is a total return index, tracking the combination of dividends and price appreciation over time. Each index is scaled to 100 at 01-01-1980. Historical cumulative outperformance since 1980 for each of the niche indices is signaled when the y-axis is greater than 1. Periods of outperformance are indicated by an upward slope in the plotted line, while downward slope point to underperformance relative to the overall market.

While relative valuation and relative performance are not the same things, I believe that they can serve as rough proxies in the long run because periods of outperformance are almost always followed by periods of underperformance. In other words, if an entire asset class has done extremely well lately, valuation risk is likely elevated going forward.

Value

The figure below depicts the historical return of value stocks relative to the overall market.

(click to enlarge)

We can see that during the 1980s and first half of the 1990s, value stocks produced returns similar to the overall market as the return ratio hovered at about 1.00. This changed during the late 1990s tech bubble, which saw value stocks dramatically underperform their high-flying growth peers. Since 2000, however, value stocks have zoomed back into a more normal relative valuation range. In the most recent cyclical bull market, value has more-or-less kept pace with growth, remaining at about the historical average. My takeaway: while value was a screaming buy at the end of the 1990s, right now it is fully valued to slightly overvalued relative to the overall market. Not a whole lot of reasons to expect outperformance going forward.

Small Caps

(click to enlarge)

The story for small caps is similar, although even more negative going forward than value stocks. After an extended period of poor performance relative to the market during the 1980s and 1990s, small caps massively outperformed in the 2000s and regained a more reasonable valuation relative to the market. In the current bull market, small caps continued their outperformance, recently approaching historical highs in relative performance. Although it is unclear where small caps are going next, their performance in the last decade was driven to a significant degree by mean reversion. So while adding a small cap allocation to your portfolio was one of last decade's great investment ideas, it does not seem so compelling nowadays.

REITs

(click to enlarge)

The story of REIT historical performance is eerily similar to small caps. After disappointing returns during the 1980s and 1990s, REIT investors enjoyed a true outperformance bonanza. Although the housing crisis brought REIT valuations back down to earth for a while, they remain at relatively high levels compared to historical standards. As interest rates eventually rise, I suspect that REITs will lose a lot of their luster as high-yield equities, so I'm passing on them as a whole until relative valuations look more compelling.

An Exception for Microcaps?

To double-check whether my findings were sensitive to index construction, I also compared the Wilshire Microcap index to the overall market, with somewhat surprising results:

(click to enlarge)

While microcaps have followed the valuation changes of small caps relative to the market, they still lag the broader market's performance since the late 1970s. So while the above figure indicates that microcaps can massively underperform during long historical periods, they don't seem to be egregiously overvalued right now.

Investment Implications

Investors can draw several conclusions from these findings. Here's three takeaways that are reflected in my current portfolio:

1.) Fans of ETFs and indexing may be better off simply holding the whole market (VTI) rather than constructing a more complicated portfolio that tilts towards small caps, value, or real estate.

2.) Stock pickers might bias their holdings towards growth rather than value. Given the weak economic environment, growth companies are often trading at discounts these days, especially in sensitive or cyclical sectors such as tech or finance. Personally, I hold Apple (AAPL) as a cheap growth play in the tech sector and BofI (BOFI) as cheap growth in the financial sector.

3.) Finally, if investors have a burning desire to throw a factor tilt kicker into their core portfolio, their best bet may be in the microcap space. Tax costs and liquidity issues make index products suboptimal vehicles for microcap exposure, so I prefer actively managed funds. In particular, I like Royce Microcap Trust (RMT), a closed end fund with an excellent track record, a 5% annual distribution yield and which trades at an 11% discount. This high distribution along with the discount provides an additional potential mechanism for outperformance if distributions are reinvested and the discount narrows over time.

In conclusion, it seems unlikely to me that the relative outperformance small caps, value and REITs in the last decade will be repeated in the coming decade. Last decade's stellar performance was due to mean reversion, a factor which can no longer propel outperformance. If anything, these types of stocks may well disappoint in the future because as a whole they are fully valued to overvalued. So while the conventional wisdom about small caps, value and REITs sounds reasonable to me, I'm avoiding ETF index strategies that include these asset classes for the time being.

Source: Avoid REIT, Small Cap And Value ETFs