Adding Some Small-Cap Value To Your Asset Mix

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If you have all your domestic stock allocation invested in an S&P 500 or Total Stock Market Index Fund like VFINX or VTSMX, here’s some interesting food for thought that I picked up from All About Asset Allocation by Richard Ferri.

Based on historical data from 1975-2004, compared to a portfolio containing 100% of a Total Market index fund (specifically the Wilshire 5000 here), a “mix of 70% in the total market and 30% in the small value index would have increased U.S. equity returns by 2.7% with no increase in portfolio volatility.” In layman’s terms, by adding a small exposure to Small-Cap Value stocks, you would have gotten more reward for the same amount of risk. Here’s a simple sketch that illustrates this:

Risk Return Graph

To me, this is a great example of how the efficient frontier works to maximize your return for a given amount of risk. While this does not guarantee that future returns will reflect this, it does cover a good stretch of time and I would it strongly suggests adding a dose of Small-Cap Value to your existing asset allocation if you haven’t already. Keep in mind that the S&P 500 and Total Market indexes are actually very closely correlated.

This is also why I moved away from all-in-one funds like Vanguard Target Retirement Funds or Fidelity Freedom Funds. While I still recommend these funds for people who value ease and simplicity, I like the ability to optimize my asset allocation. Right now, I have about 35% of my domestic stock investments in Vanguard’s Small-Cap Value Index Fund (VISVX) as part of my new overall portfolio.

This is also why I don’t have a separate Mid-Cap fund in my portfolio, as Mid-Caps are still closely correlated to Large-Caps.

Ferri also advocates Micro-Cap Index funds, but admits that good ones are hard to find. One possibility is the Bridgeway Ultra-Small Company Market (BRSIX).

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  1. Anonymous says

    I think it’s important to account for the effects of time diversification (a stupid name for a simple idea). As you hold an investment longer, that frontier moves to the left. For instance, flipping $100,000 on a coinflip that pays 1.1:1 would be very risky. But flipping $100,000 on the outcome of 100,000 coinflips is not. Similarly, the standard deviation of annual returns for an investment could be 20%. But the standard deviation for that same investment held for five years is 20%/sqrt(5), a much smaller number. This is why young investors with a longer horizon can afford substantially riskier investments (not just because they can “afford” to lose the money more than someone immedietely before retirement).

  2. Anonymous says

    This means that a 100% small-cap portfolio held over a longer time can actually have less risk than a 90% large-cap/ 10% small-cap portfolio held for a shorter time.

  3. I noticed that you invest your fixed income allocation in an intermediate term bond index.

    Compare the efficient frontiers for short term bond vs. S&P and intermediate bond vs. S&P. And take a look at the efficient frontier for bond duration.

    As bond duration increases past about 2-3 years, the increase in risk outpaces the increase in return. (See Bernstein article and Google others.) This means that you can achieve the same level of risk as your current portfolio with a smaller allocation to short term bonds. For example, if you dropped your bond allocation to, say, 8% short term, you’d have the same volatility but higher return.

  4. How can you miss out the mid-cap funds?

    YTD Performance | 1 Year | 3 Years | 5 Years | 10 Years
    Large-cap: 5.75% | 16.71% | 15.73% | 3.38% | 9.14%
    Mid-cap: 8.37% | 26.42% | 25.21% | 10.85% | 12.43%
    Small-cap: 13.92% | 33.47% | 25.67% | 10.90% | 9.58%

  5. I actually have VISVX in my Roth and BRSIX in taxable.

    BRSIX is a pretty rare offering among microcap funds (or even any small cap funds for that matter) in that it’s OK for taxable accounts. And there’s no overlap problem between BRSIX and VISVX, so they’re a good complement to each other.

  6. iShares introduced an ETF last year, the Russell MicroCap Index Fund if you want MicroCap exposure. I’ve been seriously considering it for my own asset allocation. The ticker is IWC. It invests in companies with market caps of 50MM to 550MM.

  7. Anon – That’s an interesting point. Do they have 3-D graphs that show this? That would be pretty cool.

    Blake – Yes, I’m not perfectly on the frontier. I am in the intermediate-term investment grade fund with a 5.3 year average maturity (to avoid the index fund low balance fees), as opposed to the short-term investment grade fund with a 1.7 year average maturity. I remembered that the ideal was 2-3 and decided to go on the high side, looks like I’m on the border of Bernstein’s recommendation of <5 years. Might change it in the future.

    AA – I plan on holding some Mid-Caps in a Total Stock market fund, but probably not a separate fund. Those numbers are nice (I see the 10-year is better), but still don’t convince me that they are better than having small-caps instead for the long run based on 25-year histories.

    Dan – 0.7% ER on a micro-cap fund? I’m surprised that BRSIX hasn’t closed to new investors yet! Have you done any research as to if that will happen soon? I wonder at what point small-cap fund suffer from asset bloat.

  8. Bridgeway has the epitome of ethical management and does close funds when they get big. On their website, you’ll find that several of their funds are currently closed. In fact, BRSIX only re-opened after a hiatus about a year ago. And, if you don’t mind the complexity of an additional account, you can buy directly through Bridgeway with no transaction fee.

    If you asked me a few weeks ago, I’d have predicted BRSIX would be likely to close again soon after another great run. But it did take something of a hit during the recent mini-correction, so maybe the fund will stay open a while.

  9. Hmm.. perhaps a good time to get in. I do see now that many of their other micro-cap funds are closed now. I’ll read their prospectus and check if they are offered as NTF at any of the brokerage accounts I already have.

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