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Using Small Caps To Beat The Market


  • 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

Note from the author: I would like to invite you to follow me as I build a risk-diversified portfolio designed and back-tested to generate market-like returns with lower risk. I call it the Storm-Resistant Growth portfolio. The inception-to-date results have exceeded my expectations. Take advantage of the 14-day free trial, and get immediate access to all the premium material that I have published.

This article was written by

DM Martins Research profile picture

Daniel Martins is a Napa, California-based analyst and founder of independent research firm DM Martins Research. The firm's work is centered around building more efficient, easily replicable portfolios that are properly risk-balanced for growth with less downside risk.

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Daniel is the founder and portfolio manager at DM Martins Capital Management LLC. He is a former equity research professional at FBR Capital Markets and Telsey Advisory in New York City and finance analyst at macro hedge fund Bridgewater Associates, where he developed most of his investment management skills earlier in his career. Daniel is also an equity research instructor for Wall Street Prep.

He holds an MBA in Financial Instruments and Markets from New York University's Stern School of Business.

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On Seeking Alpha, DM Martins Research partners with EPB Macro Research, and has collaborated with Risk Research, Inc.

DM Martins Research also manages a small team of writers and editors who publish content on several TheStreet.com channels, including Apple Maven (thestreet.com/apple) and Wall Street Memes (thestreet.com/memestocks).

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.

Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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Comments (5)

VBK growth has been much better than VB for 2017 and 2018
Spector99 profile picture
Why not have VTI, which includes all the big,medium,small caps of the market?.
Owned VB for many, many years. Wish i had more
DM Martins Research profile picture
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 profile picture
My wife has VB and VO. Both are rocking ETFs!!!
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