Is Small Beautiful? Four Index Choices from Vanguard by Steve Abramowitz

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.