Using Small Caps To Beat The Market

Summary

• Obsessed as I am with finding efficient ways to produce superior results, I like the idea of investing in small-cap stocks.
• My fund of choice for the past couple of years has been the Vanguard Small-Cap ETF, ticker VB.
• Investing in small caps, however, should be viewed as a generally riskier move. Investors should understand their exposure and risk tolerance.

I have written a couple of articles titled "Why Bother Picking Stocks" in which I propose the following, outside-the-box approach to beating the market over time: instead of spending time and effort trying to choose winners among the broad equities market, why not only buy the diversified basket and overlay a small quantity of leveraged S&P 500 ETF shares (UPRO) to boost the long-term return of the portfolio?

The idea did not go well with a number of readers, who thought the leveraged approach was too risky. I can appreciate these concerns. But, obsessed as I am with finding efficient ways to invest in stocks and produce superior results, I have an alternative approach - and it involves small-cap stocks.

Credit: TipRanks

At least based on historical trends, an equity investment in small companies have produced better absolute returns than a large-cap approach throughout most years. The chart below compares the performance of a small-cap ETF against that of the S&P 500 and Dow Jones indices. Notice how, even after enduring the 2008 Great Recession, small caps have outperformed stocks in general by nearly 40% cumulatively over the last ten-year period. That's about a 3.5% annual out-performance gap.

Source: Yahoo Finance

But here are the even-better news: on an adjusted basis and going back to 1972 at least, small cap stocks have produced slightly better risk-adjusted returns as well - even if at the expense of more volatility, which should matter less to the long-term investor.

The table and chart below compares portfolio 1, which is fully invested in large-cap U.S. stocks, against portfolio 2, fully allocated to small-cap domestic equities. Notice that small cap names have returned about 150 bps more than large cap counterparts per year on average, for a Sharpe ratio of 0.45 vs. the peer portfolio's 0.43, along with lower correlation against the broad market. For further comparison, the returns of the global equities ex-U.S. securities over the past 32 years have lagged those of small cap U.S. stocks by over three percentage points, while producing almost the same volatility.

Source: Portfolio Visualizer

I currently allocate a large chunk of my personal portfolio (about 25%, to be precise) to small cap stocks, as an overlay to a risk-diversified position that is at the core of my Storm-Resistant Growth portfolio strategy. That way, I hope to capture a few bps of market-outperforming returns that, compounded over the long term, I believe can add up to several thousand extra dollars in my account.

What tool to use?

Picking and choosing small-cap stocks individually, however, is not the strategy that I would advocate for most retail investors. And concentrating the investment into a few names could significantly increase the unsystematic risks, which I find undesirable.

In my case, I prefer to take advantage of low-cost ETFs that do the diversification work for me. My fund of choice for the past couple of years has been the Vanguard Small-Cap ETF (NYSEARCA:VB).

VB, live since 2004, tracks the performance of the CRSP US Small Cap Index. It charges just about the lowest management fee that an investor can hope for: 0.06% per year, which I consider to be one of the great benefits of this fund. The table below illustrates a few of the key features of the ETF, and compares is against its benchmark.

Source: Vanguard

In addition to a low turnover that is typical of passive strategies, VB is better allocated across the sectors, in my opinion, than the S&P 500. I wrote an article recently explaining why I believe most stock portfolios that use the market cap-weighted index as its benchmark might be too concentrated on pro-cyclical stocks.

In the case of VB, only 11.6% of the portfolio is invested in the tech sector, which tends to perform better in periods of economic expansion, vs. the S&P 500's 20.4%. On the flip side, VB allocates 19.2% of the fund to the more defensive consumer goods and services, compared to the S&P 500's 10%. A bit of the ETF's expected over-performance, I speculate, might be the direct result of a portfolio that I perceive to be better risk-balanced than the broad market.

Last few words

I would point out that investing in small caps should be viewed as a generally riskier move than investing in large cap stocks or in a diversified portfolio of equities and fixed income. So readers should understand their exposure and risk tolerance before moving down that path.

But once the decision to put money in small public companies is made, I believe VB is a good ETF to include on the list of possible investment vehicles.

Analyst’s Disclosure: I am/we are long VB, UPRO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Comments

[zyxw]

VBK growth has been much better than VB for 2017 and 2018

[Spector99]

Why not have VTI, which includes all the big,medium,small caps of the market?.

[kmoist]

Owned VB for many, many years. Wish i had more

[DM Martins Research]

Also wish I owned more... of anything, if I think about it. ;-)

Interestingly, VB has been under-performing the S&P 500 in the most recent several months. Probably because of the lower exposure to "hot sectors" (financials, tech especially).

[BIZUN1973]

My wife has VB and VO. Both are rocking ETFs!!!