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You’ve gone long-term the S&P 500 and you think you’re diversified. Lots of luck. Others of you are smug because you opted instead for a total market fund. At least you guys had the right idea. Truth is, neither of you is adequately spread out. Why not? Because you are horribly underinvested in small cap stocks
The S&P has absolutely zero small stocks represented, according to Morningstar’s definition. And small companies make up only 8% of the broad market alternative’s holdings. Sure, small cap stocks have been rank underperformers for almost a decade and are now on sale for nearly the cheapest price ever relative to large caps. You think you’re a market celebrity. But let’s face it folks—you were lucky, very lucky, because small companies have historically outgained larger fare by a percent or two annually.
I wrote this article for two groups of Vanguard investors. The first one comprises readers who simply didn’t know about the small stock gap in their portfolios and may want close it. A more informed bunch may already have some representation in small companies, but are considering an investment “style rebalance” that corrects for the comparatively poor showing of value stocks over the last few years. Fortunately, Vanguard offers four small cap index funds that can satisfy the needs of both types of investors. All of them have the usual Vanguard-light cost.
Small Cap Index Fund (VSMAX)
This is a plain-vanilla fund that effectively spans the universe of small companies. It fills that gap we were just talking about. Here are some numbers to give you an idea of just how poorly small cap stocks have recently done. At midyear, the fund had advanced merely 3% as against 15% for the S&P. Over the last three absolutely dismal years for small caps, their prices have stood still while the S&P has averaged a total return of almost 10% on an annualized basis. The fund’s record teaches you that small cap stocks are aggressive, dropping 24% in the 11 months starting November, 2021. It has a middling dividend of 1.7% and, importantly, is well-balanced across growth and value. There’s nothing sexy about this option, but it covers the bases.
Small Cap Growth Index Fund (VSGAX)
Get on your horse, cowboy. This growth-oriented fund is, not surprisingly, the wildest of the four. In the 11-month period from the winter of 2021 through the fall of 2022, this growthy offering lost over 30% of its value. Its volatility makes it streaky, losing 28% in 2022’s drubbing, then recovering 21% last year. Like all growth funds these days, this one is loaded with technology stocks, which explains much of its jitteriness. That overweight in a tech-dominated market accounts for much of its +4% profit by this half-year, but also its annualized 4% loss in the last three. Remarkably, only 37% of the fund is actually invested in small growth stocks, a kind of quirk that is unfortunately not unusual even in index funds. Its dividend is hardly recognizable. The fund is a straight shot at the recent surge in technology stocks, a momentum play for those so inclined. Of course, if you are a dedicated long-term investor and confident in your ability to persevere through market turbulence, the jumpiness here need not be so daunting.
Small Cap Value Index Fund (VSIAX)
Growth funds in recent years have drubbed value and created what I call a “style rebalance” opportunity. You may want to counter the overweighting of small cap technology in your portfolio by switching some of the growth fund to small cap value or by directing some new contributions to the fund. Small Cap Value has had some success lately, despite the underperformance of value stocks in general. It gained 2% in the first six months of this year and averaged 4% over the last three. Notably, this value fund gave up only 19% from the end of 2021 and the fall of 2022. Since value stocks typically pay higher dividends than their growth brethren, the small cap value fund yields 2.4%. This one might be tempting.
FTSE All-World ex-US Small Cap Index Fund (VFSAX)
Leave it to Vanguard to offer a niche foreign option, the FTSE All-World ex-US Small Cap Index Fund. But let’s be honest here—according to Morningstar, this “small cap” fund’s primary home is the midcap space. As consistent with the dour recent performance of both smaller stocks and international markets, All-World has catalogued lackluster three-year (-2%) and year-to-date (3%) records. And it has a kick, surrendering a full third of its value in the pandemic era.
But this fund has a valuable feature often characteristic of foreign small cap investments. Its correlation with your S&P or total market fund is very low (.59), making it an effective portfolio diversifier. A generous 3% dividend reflects the preference of international firms for paying out excess cash flow to shareholders rather than reinvest in the business. The cost of All-World is .17, since even Vanguard asks for a slightly higher fee for many of its international funds.
Vanguard investors have a horn of plenty when it comes to small cap options. They can be used to plug up that hole in your S&P- or total market-heavy portfolio, or favor a growth or value style.
Hi Steve. Been investing for 56 years. I had all kinds of combinations over the years with the thought of 60% stocks and 40% bonds over the years. I now align with Buffett who suggests 90% in the S&P 500, and 10% in Treasuries. My current situation is 62% S&P 8% BRK-b 23% Mag 7 Cash 17%, or 83% stocks and 17% Cash. Bonds seem outdated to me and clumsy, and my wife likes the Real Thing, Cash. My goal in a couple of years when I reach 80 years old, is 85% S&P and 15% Cash. It will all depend on taxes, and since at death your heirs get your stocks at the price on the day you perish, that is a great deal tax wise, so I doubt I will sell any stock in the Trust, that is 31% of our investments. One thing you all should reveal to young people is the magic of Compounding and taking advantage of any employee match for IRA’s. I was lucky to learn from Dad and my Engineering Economics, and so happy I did. Start investing as early as possible.
You’re so right about compounding. One of the things I find difficult is that the enormous effect of compounding happens late in the accumulation phase. Young and new investors only see the incremental impact very early on. I find I have to show them how it snowballs using a compound income calculator.
A little concerned about your high equity (especially Mag 7) stake when you seem retired and approaching your senior years. I’m assuming you have a stable source of income like an annuity to protect you in case of a severe market reversal.
Steve, I recall reading that international small cap stocks provide better foreign diversification than international large caps since the latter have become increasingly correlated with U.S. large cap stocks in recent years.
Personally, I have had an investment in VFSAX for several years. I expect that its relative performance in my portfolio will improve once U.S. big tech stocks become less dominant.
Philip, you’re totally right about international small caps being a better diversifier. Back in the old days, it was especially Japanese small caps, but I don’t know if that’s true any more.
Steve, as I understand it, the argument for better diversification from international small cap stocks is that their performance should be more affected by local economic conditions than what transpires in the U.S. economy. Hence, less chance for international small caps moving in lockstep with U.S. stocks.
Thanks. That makes a lot of sense. Similar to how our own small caps are more dependent on the local economy than the globally positioned big boys.
Steve:
As usual…good stuff!
My portfolio is currently 80% VTI, 15% VXUS and 5% BRK-B.
I hold 0% in bonds, because I have Income Annuities. Two of them will begin payment streams in August 2024 and the other two we own will begin paying income streams after January, 2029. (Most likely August, be we haven’t decided yet.). I am also considering decreasing the VXUS holding to 10% because I am simply not a fan of XUS investments. I was convinced of the wisdom of holding VXUS by my Vanguard PAS advisor. (He actually wanted me to increase it to 25-30%)
The combination of our Social Security Benefits and the two Income Annuity payments give us a 6 figure income, with only a portion of the Social Security benefits being taxable, since the income annuities were funded with Roth Dollars.
Our Vanguard holdings are currently divided as 30% Tax Free, 45% Tax Deferred, and 25% Taxable. Since I do not have a need to take withdrawals for income from these funds, and we have 2.5 years of emergency cash, we can afford to endure/enjoy the benefits of being 100% Invested in Equities. Admittedly, a more aggressive position than would be advisable for most septuagenarians, however, because I have guaranteed my income, my risk capacity can stand it.
Once we begin receive income from our second set of income annuities, in 2029, delayed until then as a guard against inflation and sequence of returns risk, I plan to reallocate the portfolio to a more conservative position.
Kevin,
Wow! A blueprint for how to combine disparate income streams into a hugely impressive financial plan. But I have a question: How can we arrange for me to be your heir……?
VTI is approximately 70% large, 20% mid, 10% small caps. VXUS is approximately 75% developed, 25% emerging. VBTLX is approximately 50% intermediate, 25% short, 25% long. How is your portfolio allocated?
You’ve got a very well diversified portfolio, especially late in the accumulation phase. I am about 85% invested in the market, which is uncharacteristically high for me. I am taking this relatively high level of risk even though I’m partly retired because I have a steady stream of passive income elsewhere coming in. My holdings are not too far from yours, except that I am about 20% in small caps and have less emerging markets. My Southeast Asia stake is very low because of the impending ratcheting up of conflict between China and Taiwan.Thanks for the interesting question.
Steve,
That is kind of light on stocks for me. I was 100% stocks in 1987, 1991, 2001, 2007, and 90% in 2021. I just started adding some bond exposure in 2024 with ishares year numbered TIPs like IBIG for 2030 in a TIPs ladder beginning in 2024 through 2033. But I know what your saying. I am thinking of upping the bond exposure but just never have felt comfortable with bonds. But as my wife says, as long as we don’t lose our original stake we’re okay.
Bond exposure could be close to zero very early in accumulation phase, but could gradually increase to 60/40 near retirement. Need bonds to protect against sharp market drop right before retirement withdrawals begin (sequence of return risk).
Steve, This is quite a different missive than normal on Humble Dollar but I thought I would respond. I have most funds at Vanguard however, I do not use all Vanguard funds. I have VTI and VXUS for my main ETF investments but along with those I chose AVUV and AVDV for Small Cap Value and EMXC for Emerging Markets. I also have DFIV for some LCV in International markets. I use SCHP for TIPS as my bond component and FLRN for cash. I knows these are not the lowest fee ETFs but the mix has done well for my wife and I. The stock portion of the portfolio is about 85% and the bond and cash portion is about 15% but of course that changes daily. What do you think? I totally enjoy all the Humble Dollar columns and get some very good ideas from them. JRV
Rick, seems you guys have done very well and you do seem to have a good deal of size, style and international diversification. My only concern is that 85/15 ratio, unless you are still early in the accumulation phase.