My concern is I don’t know if this makes sense because I’ll wind up paying a 0.3% penalty because implementing a tilt would force me to use more expensive funds in my 401(k) plan.
Given that many people debate whether there even is a small cap value premium you can capture, is it worth taking this risk if I have to start with a negative 0.3% drag right from the beginning?
The math behind the 0.3% penalty is because I’m currently using the lowest cost option in my 401(k), which is a Total US Stock Market fund at 0.53% ER. The only SCV fund in my 401(k) has a 1.43% ER, which I’ve ruled out, so I’d need to hold SCV in my IRAs. But since I’m currently holding my entire international allocation and most of my bond allocation in IRAs, doing a shift to SCV in the IRA would in turn require me to exchange from TSM in the 401(k) to international or bonds in the 401(k) to keep my overall stock/bond allocation the same. Here’s where the “penalty” kicks in: the Total Bond Fund in my 401(k) has a higher 0.83% ER, hence the 0.3% “penalty” (i.e. the difference in ER between the TSM and TBM funds in the 401(k)). The international options in my 401(k) are even worse, so I’d need to use bonds in the 401(k) if I go through with a tilt. (I hope you followed this.)
This 0.3% expense ratio penalty is on top of the extra expenses that a SCV fund has in general.
It’s one thing to implement a SCV tilt when you have good options. But is it worth doing it in my case where my options aren’t as favorable? Am I making too big of a deal about this?
I’ve found that having 52% of my retirement assets in the 401(k) (where I’m almost forced to hold TSM because the other funds are inferior and too expensive) and another 15% in a Thrift Savings Plan, with the remaining 34% in IRAs belonging to my wife and me, has held me back from doing anything too exotic.
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In that book, when he goes from "portfolio 2" to "portfolio 3" (in chapter 10), he does it by shifting 15% of the portfolio from the S&P 500 to the "Fama-French Small-Cap Index ex utilities." For portfolio 4, he shifts half of that 15% to "Fama/French U. S. Small-Cap Index." So portfolio 4 is:
The results of first adding small-cap (to get portfolio 3), then shifting half of it to small-cap value (to get portfolio 4), are as follows. Notice that (over the specific time period, using those specific indexes rather than actual mutual funds), he is showing 0.9% more annualized return but also is increasing volatility/standard deviation/"risk":
Point being, and trying to brush all controversy aside, if we take this is a rough guide to the size of the improvements slice-and-dice practitioners say you'd have gotten in the past, those are the sorts of numbers they show us. At the end, when he's finished building up to portfolio 6 (adding international small-cap and commodities), he's increased return by 1% while pushing risk back down to where it started. But that's with four extra slices, and you are just adding one.
The slice-and-dicers will have to tell you whether it's important to have both small-cap and small-cap value, or whether small-cap value by itself is good enough.
It all boils down to how much extra you actually think you're going to get (in your lifetime, not in some past period). I suspect that the knowledgeable slice-and-dicers will say that in theory you can overcome an 0.3% headwind... on the average, in the long run, etc. But the 0.3% will cancel out a meaningful chunk of the expected improvement. And the extra cost is a sure thing, while the extra return is not.
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