Is It Worth It To Tilt Your Portfolio Towards A Small Cap?
Based on the last 10-years of risk and return measures, small cap stocks are underperforming and are more volatile compared to the large cap stocks. So is it worth it to tilt your portfolio towards a small cap?
Total US Stock Market
Before we answer the question of tilting your portfolio towards small cap stocks, let’s look at the total US market fund. For instance, below are the “style” boxes for Vanguard Total US Stock Market Index Fund VTSAX. Note that the style boxes indicate that the fund contains mainly large cap blend (combination of growth and value) stocks. You can get a more granular view of the style box from morningstar.com (image on the right). Like VTSAX, the majority of Total US Stock Market Index Funds contain large cap stocks.
Surely, the large cap fund like VTSAX contains small cap stocks, 5% weight.
So why not just own the Total US Stock Market Index Fund? Why even bother increasing the complexity of your portfolio by adding small cap stocks?
To generate excess return!
“Factor In” Small Cap
By tilting your portfolio toward small cap value stocks, you are implementing a “factor investing” strategy. In theory, factor investing could potentially improve the performance of an investment or reduce risk of an investment over a long investment time horizon.
What is Factor Investing?
In factor investing strategy you target specific characteristics of an investment to potentially improve the performance of a portfolio or reduce the risk of a portfolio. The most common factors are value, momentum, size, quality and volatility.
In this article we will be discussing small and value factors.
Following are the “style” boxes of a small cap value fund (VISVX) from Vanguard and Morningstar. The small cap stocks represent 52% weight in comparison to 5% weight for the Total Market Index Fund (VTSAX).
Albeit, there is “no free lunch” as small cap stocks are in general more volatile and risky in the short-term in comparison to large cap stocks. But it may also have higher growth potential in the long-term in comparison with large cap stocks.
So if you can tolerate short-term volatility, “tilting” your portfolio toward small cap stocks may improve your portfolio’s performance.
Small Cap and Excess Return
Excess return from small cap stocks means additional return compared to large cap stocks. Since 1972 to 2020, small cap stocks have outperformed large cap stocks by 1.14%. The small cap value stocks have outperformed large cap stocks even more, by 3.01%. Here is the comparison of large cap, small cap and small cap value from 1972 to 2020 (source: Portfoliovisualizer.com).
| 1972-2020 | CAGR* | Standard Deviation |
|---|---|---|
| Large Cap Stocks | 10.26% | 15.25% |
| Small Cap Stocks | 11.40% | 19.59% |
| Small Cap Value Stocks | 13.27% | 18.22% |
As expected with higher return, standard deviation (volatility) for small cap and small cap value is higher than the large cap stock.
How did small cap stocks perform in a shorter time period?
Not so well. See the table below.
| Time Frame | Large Cap | Small Cap | Small Cap Value |
|---|---|---|---|
| 2010-2020 | 12.58% | 11.16% | 9.07% |
| 2015-2020 | 10.31% | 6.61% | 3.17% |
| 2018-2020 | 9.31% | 3.43% | -3.45% |
| 2020: Year-to-Date | 2.65% | -4.50% | -15.78% |
Following is the graphical representation of the table above.
As you can see the “excess” return is not without a “pain”. During the shorter time periods, small cap stocks underperform as shown in the table/graph above. In fact, small cap value stocks have negative returns in the last one year to three years time periods.
However, the historical data suggests small cap stocks generating “excess” return over a longer time horizon, outperforming large cap stocks.
Excess Return
How much 1.14% “excess” return by small cap stocks over large cap stock generates over time? Let’s crunch some numbers.
For instance, your $10,000 investment in large cap stock from 1972 to 2020 would have grown to $1,180,786. On the other hand, the $10,000 invested in small cap stocks instead would have grown to $1,948,207. The difference is $767,421!
It gets even better with small cap value which generated 3.01% in “excess” return over large cap stock from 1972 to 2020. The initial $10,000 investment would grow to $4,385,328; the difference of $3.2 million dollars!
So is it worth it to tilt your portfolio towards a small cap? It definitely requires some consideration.
Small Cap Tilt
Even though historical data suggests that small cap value would generate thousands of dollars of “excess” return, I do not have an appetite to handle excessive risk. So I would not go for 100% small cap or 100% small cap value stocks allocation. Instead, I would “tilt” my portfolio toward small cap stocks. The general suggestion is to “tilt” 10% to 30% of total stock allocation toward small cap stock.
Let’s compare the three hypothetical portfolios.
- Portfolio 1: 100% large cap stocks
- Portfolio 2: with 20% small cap tilt; 80% large cap stocks / 20% small cap stocks
- Portfolio 3: with 20% small cap value tilt; 80% large cap stocks / 20% small cap value stocks
Following table is the comparison of the three portfolios (Source: Portfoliovisualizer.com).
| Portfolio | Tilt | CAGR | Standard Deviation | $10,000 Growth 1972-2020 |
|---|---|---|---|---|
| Portfolio 1 | No Tilt | 10.26% | 15.25% | $1,180,786 |
| Portfolio 2 | 20% Small Cap | 10.58% | 15.68% | $1,357,680 |
| Portfolio 3 | 20% Small Cap Value | 11.00% | 15.40% | $1,632,995 |
Note that the CAGR and the growth dollar are nominal (not adjusted for inflation).
Notice that standard deviation with 20% “tilt” towards small cap stocks is similar to 100% large cap stock portfolio. But the returns with a “tilt” are higher.
Although, CAGR looks small between the portfolio, it generates thousands of dollars in “excess” return. For instance, a mere 0.32% difference between Portfolios 2 and 1 would generate additional $176,894. While the difference of 0.74% between Portfolio 3 and 1 would generate additional $452,209.
Conclusion
So is it worth it to tilt your portfolio towards a small cap?
Yes! If you have a 20 to 30 years investment time horizon, an appetite for taking risk and discipline to “stay the course”. But if high volatility and potential anxiety over negative returns in the short-term keeps you up at night, it may not be worth it.
As I said before, “there is no free lunch”, the cost of “excess” return would be under performance or negative performance in the short-term.
In conclusion, if you decide to “tilt” your portfolio towards small cap stocks, you may have to be disciplined and committed to the strategy over a long period of time to get the benefit of the “excess” return.
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