- 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.
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.
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.
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
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.
- - -
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.
- - -
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.