Small-cap value index vs. Small-cap index

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Carolann
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Small-cap value index vs. Small-cap index

Post by Carolann »

U-turn? I'm 67, retired, have been investing in Index Funds for years. My long term plan has been to move about 3%- 5% into a small-cap index fund, and I've done that. (At my age I'm about 40% fixed income, and the rest indexed International & US) This money is in a taxable account, as part of a plan to have more fixed-income in the IRA and less in the taxable account.

But... oops, did some reading on Small Caps. Fama & French as quoted by Wm Bernstein in "Four Pillars of Investing", p. 36, 2002, says there's a substantial advantage to small-cap VALUE indexing, over 1926 - 2000. I've also looked at the 1, 3, 5, and 10 year returns from 2000 - 2010 on Vanguard website (Am I allowed to say Vanguard? This is my first post!) It looks as if the “Small-cap value Index” returns are ahead of the of the “Small-Cap Index fund” and even the “Tax-managed small-cap”, even after taxes.
So, I'm about to do a u-turn & put the money into "Small-cap value index" instead of the Small-cap index or Small-cap tax-managed.
Am I missing something here, or do about 80 years of figures substantiate the small-cap value advantage? If it's really there, why hasn't it disappeared because everyone knows about it?
Rodc
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Post by Rodc »

Good questions.

The small premium and the value premium come and go. Nothing in investing is a sure bet all the time. Or rather, the more sure the bet the lower the expected return, and often in fact the actual return. Short term treasury bills are very safe, and return little. Riskier assets like stocks generally return more over time, but risk is real, you may lose!

Since small value has both extra risk due to small companies and value companies, it has provided higher returns over very long periods of time. It might not going forward, risk is real. And even if it does, it might be on a time scale that is too long for you.

No one really knows.

If you tilt small value, it would be wise to shift a little more towards bonds.

These links might be of interest:

http://home.comcast.net/~rodec/finance/ ... _error.pdf

http://www.bogleheads.org/forum/viewtopic.php?t=9445

http://www.bogleheads.org/forum/viewtopic.php?t=11877

But one should always remember that the past does not guarantee the future. Markets can stay irrational longer than you can stay solvent. Past data may be of poor quality. Etc. Which is to say, all caveats apply.

Best of luck with your investing.

And remember: it is often better to stick with a good enough plan than to keep changing plans looking for a perfect plan.
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.
livesoft
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Post by livesoft »

You may enjoy reading some of the online articles found linked on the right-hand-side at www.fundadvice.com

But as Rodc points out, small cap value has performed better historically than small cap blend because it is riskier. SCV drops more than SC in times of distress. We know history (in theory), but we cannot predict the future.

Can you accept the risk and the volatility?
DaveS
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Post by DaveS »

Over time Small Growth tends to under perform. The theory, as explained in Larry Swedroe's first book, is that people continuously bid up the price of small growth stocks hoping they are buying "the next Microsoft." As a result such stocks are often priced too high and returns are low. It is one of several reasons to tilt to small value. Dave
rwwoods
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Post by rwwoods »

In his latest book "The Only Guide You'll Ever Need for the Right Financial Plan", Larry Swedroe writes that from 1927 through 2008:
the average annual equity risk premium over 3 mos T bills was 7.5 %
small stocks had a risk premium of 3% over large stocks
small cap value stocks had a risk premium of 5% over growth stocks.

I think one of the better small cap value funds is Rydex S&P SmCap 600 Pure Value ETF (RZV). It is one of most "valueey" funds.
"I'm not so much concerned about the return on my money as the return of my money" - Will Rogers
richard
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Re: Small-cap value index vs. Small-cap index

Post by richard »

Fama French say that the reason small value has performed better than the market generally is that it's riskier. Risk includes that possibility of much worse future performance. There's certainly no guarantee that history will repeat itself.

There's no such thing as free lunch.

Small value is not very tax efficient. As companies get bigger and better they have to be sold, which means capital gains. SV funds haven't looked that bad from a tax point of view recently because they haven't been doing that well (less need to sell winners if fewer winners).

Bernstein is a big fan of small value, but even he has warned about SV in taxable.

On the other hand, a danger of SV is that it's tied to the economy, investors risk portfolio losses and job losses at the same time. As a retired person, you may be better able to bear the risk than others.
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nisiprius
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Post by nisiprius »

I was curious, and is my wont I always look at the growth charts, in this case between NAESX and VISVX. And is frequently the case, I don't know how to interpret what I'm seeing. So don't look for some actual point I'm making, this is just musing. But here are the charts. This one is honest because it's for the full time VISVX has existed, i.e. I didn't pick the period.

Image

And my reaction is "huh. Who knows?" Nothing in that chart suggests a huge difference risk to me. And, given the vagaries of stock funds, the fact that Small Cap Value ended up beating Small Cap Index isn't overwhelmingly impressive. Figuring the time period as 13 years I make out the annualized returns to be about 4.2% for small-cap versus 5.1% for small-cap value.

Now, when I overlay Total Stock Market on top, there's a case to be made for small-cap value because it went up during 2000-2004 when Total Stock Market was going down, so it was doing its valuable diversification thing. And yet, perhaps it should be noted that boring old Total Bond Market did just about as well during that time period and would have been just as effective as Small Value at offsetting Total Stock:

Image

One thing for sure. Over the period 2001-2010, it sure didn't make much difference which fund you were in.

Image
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Carolann
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Thanks!

Post by Carolann »

Hello -
Thanks for the comments. Much food for thought in the suggested websites! Will hold the SCV index in a Roth account. What was I thinking, to put it in the taxable account :roll: Even as an index fund, I see that there will have to be ups and downs and capital gains distributions.

Will entertain myself over the next 20 years, if I live so long, watching to see if the Fama & French figures hold up in the future, or if the SCV advantage disappears.

Y'all are pretty clever! Thanks!
Carolann
retiredjg
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Post by retiredjg »

Carolann, I'm wondering about your percentage of fixed income. At 67 years old, I would think 50% or 60% fixed would be more appropriate than 40% fixed. Of course, there are exceptions. Is there a reason your portfolio is so aggressive at age 67?

Obviously, it's none of my business and you don't have to answer, but you should definitely think about it (if you have not already).

I'm a small value fan myself. And SV can be put in taxable. It's not the best choice, in my opinion, but it can go there without a big tax hit. And if you are using the income, it does not really matter if you are paying taxes on it anyway.
letsgobobby
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Post by letsgobobby »

off topic, but WHY is small cap value riskier than small cap blend (and by extension small cap growth)? Why is value more volatile than growth?
stlutz
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Post by stlutz »

Historically, value has been *less* volatile than growth.

For the efficient market hypothesis to be true, the outperformance of value *must* mean that it's more risky. Hence, value gets called a "risk factor." If you don't posit that the EMH is true, it's historical outperformance can be due to any number of factors:

a) it is riskier
b) investors consistently misjudge companies--a fact you can take advantage
of
c) value hasn't really outperformed; the alleged outperformance is mainly due to assumptions that were made in working with very old databases.

I personally fall somewhere between (b) and (c), but (a) has actually been false historically.
SteveB3005
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Post by SteveB3005 »

A very good conversation back in May 2007 on Small Cap Value location and tax consequences brought up that historically even with the higher turnover and the tax drag of rebalancing and booting out the winners and adding dogs the Small Cap Value still had about 1.3% performance advantage over TSM held in taxable accounts.

There are other considerations as Larry Swedroe pointed out here in that conversation.

The only equities that belong in tax advantaged accounts as preference are REITS---

and went on to add.....


Holding SV in tax advantaged accounts loses these benefits
a) converts capital gains into ordinary income
b) loss of ability to harvest losses--and not only is this valuable, the more volatile an asset class the more valuable it becomes, and SV is high volatility asset class
c) cannot donate appreciated shares to charity
d) lose potential for stepped up basis for heirs, a very valuable benefit
Beagler
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Post by Beagler »

Image

I love this chart.
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letsgobobby
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Post by letsgobobby »

SteveB3005 wrote:A very good conversation back in May 2007 on Small Cap Value location and tax consequences brought up that historically even with the higher turnover and the tax drag of rebalancing and booting out the winners and adding dogs the Small Cap Value still had about 1.3% performance advantage over TSM held in taxable accounts.

There are other considerations as Larry Swedroe pointed out here in that conversation.

The only equities that belong in tax advantaged accounts as preference are REITS---

and went on to add.....


Holding SV in tax advantaged accounts loses these benefits
a) converts capital gains into ordinary income
b) loss of ability to harvest losses--and not only is this valuable, the more volatile an asset class the more valuable it becomes, and SV is high volatility asset class
c) cannot donate appreciated shares to charity
d) lose potential for stepped up basis for heirs, a very valuable benefit
a) - no more or less than for any other asset class. The tax-deferred compounding especially for high-expected return asset classes outweighs this over periods of time.
b) - a good point.
c) - IRAs can be used to donate directly to charity and no one pays taxes - very useful. Not sure why he wrote this.
d) - true, but this is not everyone's primary (or secondary) concern. For a Roth IRA it would not apply at all, since no taxes are owed whatsoever, the presence/absence of stepped up basis would be irrelevant.
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jeffyscott
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Re: Small-cap value index vs. Small-cap index

Post by jeffyscott »

Carolann wrote: If it's really there, why hasn't it disappeared because everyone knows about it?
Perhaps it has, as of about 5 years ago?

http://quote.morningstar.com/fund/chart ... %2C0%22%7D
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MachAF
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Post by MachAF »

Graphs can be very misleading. I believe Bernstein talks about this in one of his books.

Change the date to 10yrs and look at the difference.
SteveB3005
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Post by SteveB3005 »

letsgobobby wrote:
SteveB3005 wrote:A very good conversation back in May 2007 on Small Cap Value location and tax consequences brought up that historically even with the higher turnover and the tax drag of rebalancing and booting out the winners and adding dogs the Small Cap Value still had about 1.3% performance advantage over TSM held in taxable accounts.

There are other considerations as Larry Swedroe pointed out here in that conversation.

The only equities that belong in tax advantaged accounts as preference are REITS---

and went on to add.....


Holding SV in tax advantaged accounts loses these benefits
a) converts capital gains into ordinary income
b) loss of ability to harvest losses--and not only is this valuable, the more volatile an asset class the more valuable it becomes, and SV is high volatility asset class
c) cannot donate appreciated shares to charity
d) lose potential for stepped up basis for heirs, a very valuable benefit
a) - no more or less than for any other asset class. The tax-deferred compounding especially for high-expected return asset classes outweighs this over periods of time.
b) - a good point.
c) - IRAs can be used to donate directly to charity and no one pays taxes - very useful. Not sure why he wrote this.
d) - true, but this is not everyone's primary (or secondary) concern. For a Roth IRA it would not apply at all, since no taxes are owed whatsoever, the presence/absence of stepped up basis would be irrelevant.
a) Fair enough it certainly could be dependent on the current capital gains rate , the investors tax bracket in the withdrawl phase ,and if you have the room in tax-advantaged to harbor the equities without displacing fixed income vehicles.

c) If my understanding is correct Larry's point is in an IRA you are not donating actual shares that you received the favorable stepped up basis, but converted dollars which do have tax implications. Furthermore, and again my understanding, the IRS rules are if donating before age 70 1/2 individuals must take the taxable withdrawal from the IRA and then donate. The break comes after age 70 1/2 when you can directly transfer from retirement accounts up to $100,000 that otherwise would be taxable income.
Beagler
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Post by Beagler »

MachAF wrote:Graphs can be very misleading. I believe Bernstein talks about this in one of his books.

Change the date to 10yrs and look at the difference.
More importantly, look at the model portfolios in his books.
“The only place where success come before work is in the dictionary.” Abraham Lincoln. This post does not provide advice for specific individual situations and should not be construed as doing so.
SteveB3005
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Post by SteveB3005 »

Carolann wrote: If it's really there, why hasn't it disappeared because everyone knows about it?
The fact that is has not gone away allready makes me think the value premium will continue for at least two reasons and especially in small caps where the indexed funds outperformance of active funds is even greater than in large cap funds.

1) The fund is not static... every rebalance brings new distressed stocks as others companies leave with their share price having been run up and becoming growth stocks.

2)Winners are so hard to spot...the outperformance of the index is attributable to only a handful of stocks and the bets are fairly evenly placed. The top ten in the S&P Small Value account for less than 10% of the fund and in the S&P 500 the top ten comprise 20% and the top fifty nearly 50%.

Edit: syntax and clarify
Last edited by SteveB3005 on Sat Aug 28, 2010 7:54 am, edited 4 times in total.
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jeffyscott
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Post by jeffyscott »

MachAF wrote:Change the date to 10yrs and look at the difference.
But my point was to suggest that perhaps "everyone knew about" small cap value only as of 5 years ago.
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