Why is small cap value so special?

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s8r
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Why is small cap value so special?

Post by s8r » Wed Oct 02, 2019 10:33 am

What makes small cap value so special? Isn't it just like all the other factors: past outperformance is believed to result in future outperformance. And to achieve this future outperformance an equal amount of market capital that "believes" the factor will in fact underperform is needed.

The reasoning why small cap value should outperform in the future sounds quite flimsy to me. Am I missing something?

retiredjg
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Re: Why is small cap value so special?

Post by retiredjg » Wed Oct 02, 2019 12:55 pm

We know that value and small outperformed in the past. Some people think that will continue and try to capture both in 1 fund. I don't know the reasoning - as far as I know, it is only opinion, nothing based in fact. Nobody knows if it will help or not. I don't think you are missing anything.

jebmke
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Re: Why is small cap value so special?

Post by jebmke » Wed Oct 02, 2019 1:24 pm

retiredjg wrote:
Wed Oct 02, 2019 12:55 pm
We know that value and small outperformed in the past. Some people think that will continue and try to capture both in 1 fund. I don't know the reasoning - as far as I know, it is only opinion, nothing based in fact. Nobody knows if it will help or not. I don't think you are missing anything.
Fama and French had more than one journal article on this quite a long time ago - I want to say early 90s. Quite a bit of work has been done on this. It still remains a point of discussion, of course. My wife's firm was investing in Small and MidCap value-only pools in the mid-80s before the academic work came out later. We had much of our portfolio in their pension pool for over 20 years. Tracking error is significant. During the tech boom it underperformed but barely lost money (one year) when the tech bust hit. Perhaps fortunately for us it only reported results on December 31 so we didn't constantly face behavioral issues of staying or leaving the pool.
When you discover that you are riding a dead horse, the best strategy is to dismount.

KyleAAA
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Re: Why is small cap value so special?

Post by KyleAAA » Wed Oct 02, 2019 1:32 pm

You are missing a lot. There is no requirement that an "equal amount of capital believe they will underperform." Stocks are still largely bought and sold individually for various reasons, despite the conventional wisdom on here. To the extent the small and value premiums are a risk story, it doesn't represent out-performance, but just additional return in exchange for taking on additional risk. Same logic as going from 70% stocks to 100% stocks. You are taking on additional risk and expect to earn additional return. This would imply market beta does not fully encapsulate the risk of owning stocks, which isn't exactly a controversial statement.

alex_686
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Re: Why is small cap value so special?

Post by alex_686 » Wed Oct 02, 2019 1:42 pm

My personal theory is that they are boring companies with few analysis following them. Therefore, ignored by professionals and incorrectly underpriced. While I do think that was true 30 years ago, I don't think it is true today. Current economic structures favor large companies over small. Anybody with a Bloomberg terminal can find these companies today and private equity funds have snapped up all of the good ones.

There are 2 other theories that still hold today - maybe.

The first is that the small cap value index and the price history surrounding small cap value stocks is wrong. These stocks tend to be thinly traded. Indexes are theoretical constructs that get to ignore this. They ignore the bid-ask spreads, they ignore that if you actually tried to trade into these stocks you would actually bump up the price.

The second is that you are not accounting for risk. Companies tend to do fine, but a few disintegrate into bankruptcy without warring. This particular tail risk - infrequent high impact events - does not model well when figuring out risks. For small cap value this is doubly true.

Schlabba
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Re: Why is small cap value so special?

Post by Schlabba » Wed Oct 02, 2019 2:02 pm

KyleAAA wrote:
Wed Oct 02, 2019 1:32 pm
... just additional return in exchange for taking on additional risk. ...
That should be priced in. If it would be such a clear case that small cap value would outperform because of the wilder swings, then why don't we all outperform by holding large allocations to small caps?

I believe the market is only getting more and more efficient. The more research finds some effect happened in the past, the more effectively it gets priced in. Just because there were market inefficiencies in the '50s doesn't mean we can count on that going forward into the future.

Internet must have made the market more efficient. Maybe in the future A.I. based trading will remove inefficiencies faster than you can open a PDF file with financial statements.
IWDA: MSCI World | EMIM: MSCI Emerging Markets | AGGH: Global Aggregate Bond Hedged to €

dcabler
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Re: Why is small cap value so special?

Post by dcabler » Wed Oct 02, 2019 2:07 pm

I believe that it's definitely a risk story where the risk has historically been compensated for the patient ones. I do think that factors, as currently defined (and being redefined with the addition of things like quality, momentum, etc) do make sense historically. Whether it will continue or, perhaps, will we have to wait a really long time before it shows up again, who knows?

The way I think of it is that, yes, there are periods of underperformance relative to a pure Beta-based portfolio, but in all of my looking backwards I've never seen anything that I would define as "catastrophic", relative to a pure Beta portfolio. In other words, might help and if it doesn't, is unlikely to hurt much. Plus, it's pretty hard to find a small cap value fund that doesn't historically have a Beta close to 1.0 anyway. In my own portfolio, I do invest in SCV and have chosen funds that seem to also have a positive quality factor as well, hopefully removing junk from the index. Time will tell how well this works out, but so far I've not been disappointed, even when we have years like this year where SCV has underperformed a TSM approach.

Cheers.

dcabler
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Re: Why is small cap value so special?

Post by dcabler » Wed Oct 02, 2019 2:30 pm

Schlabba wrote:
Wed Oct 02, 2019 2:02 pm
KyleAAA wrote:
Wed Oct 02, 2019 1:32 pm
... just additional return in exchange for taking on additional risk. ...
That should be priced in. If it would be such a clear case that small cap value would outperform because of the wilder swings, then why don't we all outperform by holding large allocations to small caps?

I believe the market is only getting more and more efficient. The more research finds some effect happened in the past, the more effectively it gets priced in. Just because there were market inefficiencies in the '50s doesn't mean we can count on that going forward into the future.

Internet must have made the market more efficient. Maybe in the future A.I. based trading will remove inefficiencies faster than you can open a PDF file with financial statements.
Some people do, or at least they suggest that it's possible. At least one version of the "Larry Portfolio" does this. While I count myself among the fans of small and value factors, not sure I'd be so brave as to go that far. :D

KlangFool
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Re: Why is small cap value so special?

Post by KlangFool » Wed Oct 02, 2019 2:40 pm

OP,

There are two ways to play SCV.

A) Use SCV to get higher risk and higher returns. As a standalone.

B) Use SCV as part of the BarBell / Larry portfolio. Aka, pairing SCV with treasury bond (strong safety). Use it to construct a portfolio.

I do (B).

The question to you is this. Do you believe in (A) or (B) or both or neither?

As per my experience so far, (B) works very well.

KlangFool

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Taylor Larimore
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Re: Why is small cap value so special?

Post by Taylor Larimore » Wed Oct 02, 2019 3:00 pm

The reasoning why small cap value should outperform in the future sounds quite flimsy to me. Am I missing something?
s8r:

You are not "missing" anything. You can read my opinion of factor funds here:

Factor Investing

Best wishes.
Taylor
Jack Bogle's Words of Wisdom: "By and large I do not approve of factor funds."
"Simplicity is the master key to financial success." -- Jack Bogle

KyleAAA
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Re: Why is small cap value so special?

Post by KyleAAA » Wed Oct 02, 2019 3:17 pm

Schlabba wrote:
Wed Oct 02, 2019 2:02 pm
KyleAAA wrote:
Wed Oct 02, 2019 1:32 pm
... just additional return in exchange for taking on additional risk. ...
That should be priced in. If it would be such a clear case that small cap value would outperform because of the wilder swings, then why don't we all outperform by holding large allocations to small caps?

I believe the market is only getting more and more efficient. The more research finds some effect happened in the past, the more effectively it gets priced in. Just because there were market inefficiencies in the '50s doesn't mean we can count on that going forward into the future.

Internet must have made the market more efficient. Maybe in the future A.I. based trading will remove inefficiencies faster than you can open a PDF file with financial statements.
It IS priced in. The premium wouldn't exist if it weren't. Nobody is necessarily arguing the small/value premium represents an inefficiency. The risk-based explanation argues the exact opposite, in fact. I don't know why you don't hold large allocations to small cap value. Maybe you should?

Schlabba
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Re: Why is small cap value so special?

Post by Schlabba » Wed Oct 02, 2019 3:34 pm

KyleAAA wrote:
Wed Oct 02, 2019 3:17 pm
Schlabba wrote:
Wed Oct 02, 2019 2:02 pm
KyleAAA wrote:
Wed Oct 02, 2019 1:32 pm
... just additional return in exchange for taking on additional risk. ...
That should be priced in. If it would be such a clear case that small cap value would outperform because of the wilder swings, then why don't we all outperform by holding large allocations to small caps?

I believe the market is only getting more and more efficient. The more research finds some effect happened in the past, the more effectively it gets priced in. Just because there were market inefficiencies in the '50s doesn't mean we can count on that going forward into the future.

Internet must have made the market more efficient. Maybe in the future A.I. based trading will remove inefficiencies faster than you can open a PDF file with financial statements.
It IS priced in. The premium wouldn't exist if it weren't. Nobody is necessarily arguing the small/value premium represents an inefficiency. The risk-based explanation argues the exact opposite, in fact. I don't know why you don't hold large allocations to small cap value. Maybe you should?
I sometimes play with the idea of adding a value and/or smallcap fund to my holdings. Its not a bad decision to tilt a little.

I am just not convinced enough so that I can hold it for a decade without worrying about it.
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JAZZISCOOL
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Re: Why is small cap value so special?

Post by JAZZISCOOL » Wed Oct 02, 2019 4:02 pm

You may like to read this BH post on Fama French 3-factor model which discusses the "small/size" and "value" risk factors that they believe will produce a higher expected return for a portfolio with these "tilts" over time:

https://www.bogleheads.org/wiki/Fama_an ... ctor_model

As has been discussed on BH and in the financial press, growth has been outperforming value in recent years so the higher expected return for "value" in particular has not materialized vs. cap weighted market indices. Small caps have also trailed large caps. IMO, one has to be a patient investor if you decide to implement these factors in your portfolio.

The Cross‐Section of Expected Stock Returns
EUGENE F. FAMA
KENNETH R. FRENCH
First published: June 1992

https://onlinelibrary.wiley.com/doi/ful ... .tb04398.x

BH's podcast guru, Rick Ferri, has an interesting interview with Larry Swedroe where he discusses the Fama French factors (1992 research paper) around minute 17 or so that you might enjoy ("Bogleheads on Investing" is the name of the podcast; on iTunes, etc.) He discusses another factor ("momentum") introduced by University of Chicago PhD, Mark Carhart, in 1997, in addition to other factors introduced later by other academics as explanatory factors of market returns.

Elysium
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Re: Why is small cap value so special?

Post by Elysium » Wed Oct 02, 2019 6:44 pm

s8r wrote:
Wed Oct 02, 2019 10:33 am
What makes small cap value so special? Isn't it just like all the other factors: past outperformance is believed to result in future outperformance. And to achieve this future outperformance an equal amount of market capital that "believes" the factor will in fact underperform is needed.

The reasoning why small cap value should outperform in the future sounds quite flimsy to me. Am I missing something?
OP, It isn't special, some people are looking at data mined returns from the past that has failed to materialize in reality. In fact, SCV is the opposite of special, they are stocks of debt laden distressed companies with high cost of capital and low liquidity. Some people believe by taking on this risk they will get an extra reward, but the trouble is the risk is real and you may not get the reward.

KyleAAA
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Re: Why is small cap value so special?

Post by KyleAAA » Thu Oct 03, 2019 10:06 am

Elysium wrote:
Wed Oct 02, 2019 6:44 pm
s8r wrote:
Wed Oct 02, 2019 10:33 am
What makes small cap value so special? Isn't it just like all the other factors: past outperformance is believed to result in future outperformance. And to achieve this future outperformance an equal amount of market capital that "believes" the factor will in fact underperform is needed.

The reasoning why small cap value should outperform in the future sounds quite flimsy to me. Am I missing something?
OP, It isn't special, some people are looking at data mined returns from the past that has failed to materialize in reality. In fact, SCV is the opposite of special, they are stocks of debt laden distressed companies with high cost of capital and low liquidity. Some people believe by taking on this risk they will get an extra reward, but the trouble is the risk is real and you may not get the reward.
The exact same argument applies to stocks, generally. You just argued against investing in stocks.

Elysium
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Re: Why is small cap value so special?

Post by Elysium » Thu Oct 03, 2019 10:24 am

KyleAAA wrote:
Thu Oct 03, 2019 10:06 am
Elysium wrote:
Wed Oct 02, 2019 6:44 pm
s8r wrote:
Wed Oct 02, 2019 10:33 am
What makes small cap value so special? Isn't it just like all the other factors: past outperformance is believed to result in future outperformance. And to achieve this future outperformance an equal amount of market capital that "believes" the factor will in fact underperform is needed.

The reasoning why small cap value should outperform in the future sounds quite flimsy to me. Am I missing something?
OP, It isn't special, some people are looking at data mined returns from the past that has failed to materialize in reality. In fact, SCV is the opposite of special, they are stocks of debt laden distressed companies with high cost of capital and low liquidity. Some people believe by taking on this risk they will get an extra reward, but the trouble is the risk is real and you may not get the reward.
The exact same argument applies to stocks, generally. You just argued against investing in stocks.
That's an absurd statement. Investing in the broad market portfolio consisting of high quality companies that represent the bulk of the publicly traded US equities is not the same as overweighting debt laden distressed companies with low liquidity that are a small sliver of that broad market. SCV is 2% of the broad market, and correctly represented in the market portfolio. There is no equivalency here.

Elysium
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Re: Why is small cap value so special?

Post by Elysium » Thu Oct 03, 2019 10:24 am

duplicate deleted

KyleAAA
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Re: Why is small cap value so special?

Post by KyleAAA » Thu Oct 03, 2019 11:44 am

Elysium wrote:
Thu Oct 03, 2019 10:24 am
KyleAAA wrote:
Thu Oct 03, 2019 10:06 am
Elysium wrote:
Wed Oct 02, 2019 6:44 pm
s8r wrote:
Wed Oct 02, 2019 10:33 am
What makes small cap value so special? Isn't it just like all the other factors: past outperformance is believed to result in future outperformance. And to achieve this future outperformance an equal amount of market capital that "believes" the factor will in fact underperform is needed.

The reasoning why small cap value should outperform in the future sounds quite flimsy to me. Am I missing something?
OP, It isn't special, some people are looking at data mined returns from the past that has failed to materialize in reality. In fact, SCV is the opposite of special, they are stocks of debt laden distressed companies with high cost of capital and low liquidity. Some people believe by taking on this risk they will get an extra reward, but the trouble is the risk is real and you may not get the reward.
The exact same argument applies to stocks, generally. You just argued against investing in stocks.
That's an absurd statement. Investing in the broad market portfolio consisting of high quality companies that represent the bulk of the publicly traded US equities is not the same as overweighting debt laden distressed companies with low liquidity that are a small sliver of that broad market. SCV is 2% of the broad market, and correctly represented in the market portfolio. There is no equivalency here.
You made an argument but are irrationally selective about how it is applied. The argument you made does, in fact, unambiguously apply to the total stock market. There have been long stretches where stocks have underperformed bonds. The risk is always there even if the return is not. Your argument does not require that investing in broad market portfolios consisting of high quality companies be equivalent of investing in debt-laden distressed companies (which doesn't actually describe small/value companies generally and in fact most investable small value indexes contain a quality filter, a liquidity filter, or both. But that's another discussion). For your point to be logically consistent, you'd have to assume that valuation doesn't matter. But we know it does. The fact that large growth companies are less likely to go out of business in the next 10 years compared to small value companies is accounted for in valuations. The fact that small value companies only account for a few % of the overall stock market is also irrelevant to your argument.

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