In Defense Of Small Cap Value

In Defense Of Small Cap Value

There are multiple reasons that could explain its underperformance.

Reviewed by: Allan Roth
Edited by: Allan Roth

It’s been a pretty rough decade—and longer—to stay the course on smart beta. Those supposedly smaller underpriced stocks were trounced by the large cap growth stocks believed to be so obviously overvalued.

In the 10 years ending May 19, 2020, the iShares Morningstar Small Cap Value ETF (JKL) earned a total return of only 5.09% annually versus the iShares Russell 1000 Growth ETF (IWF) clocking in a 15.19% return.

To put that in perspective, a $10,000 investment in JKL earned $6,435, while IWF earned $31,116, or nearly five times the amount. The past five years have been especially brutal for small value and great for large growth.


I’m probably the last guy one would expect to defend small cap value. Over five years ago, I wrote why I believed in “dumb beta” and was sticking with basic boring market-cap-weighted index funds. And I followed through noting that Fama and French never said the three-factor model was a free lunch. But I wouldn’t necessarily advise abandoning that strategy now.


Why The Underperformance?
In a recent piece co-authored by Rob Arnott of Research Affiliates, he made the case that the reports of value’s death may be greatly exaggerated. I agree, and extrapolate that to include both value and small cap. The article noted that possible explanations for underperformance include:

  1. The value investing style, or factor, could be a product of data mining.
  2. The structural changes in the market could have caused the value factor to become irrelevant.
  3. The value trade could have become crowded.
  4. Could have been a “left-tail” outlier, or simple bad luck.
  5. The value factor is becoming cheaper.


I endorse all of these reasons. I still see data mining when people quote returns over several decades even though they hadn’t been investing in small cap value for most of that period. And the economy has changed dramatically toward tech and online transactions and away from brick and mortar. The current pandemic only increases the trend.

Small cap value became incredibly crowded when years ago I couldn’t go more than 30 seconds at an investment conference without hearing the terms “smart beta” or “factor investing.” I think the underperformance is an extreme left-tail statistically improbable event. Finally, no one can argue that valuations of small cap value are far more attractive today than they were a decade ago.


Case For Small Cap Value
None of the reasons above are, by themselves, reasons to predict small cap value will outperform over the next decade. But today, I’m hearing pretty much just the opposite.

  1. Data mining (including my graph) showing how spectacularly large cap growth has performed.
  2. Arguments that tech will continue to grow faster as though they are the only ones that have realized it and it hasn’t already been priced into the market.
  3. I now rarely see arguments for small cap growth and, far more often, see tech being crowded.
  4. The incredible outperformance of large-cap growth tech stocks is a “right-tail” outlier and simple good luck.
  5. The growth factor is becoming expensive.


My Advice Going Forward
I think it’s very unlikely (but not impossible) that small cap value lags large cap growth by nearly the same amount over the next 10 years. And because, as Fama and French have said, it’s compensation for taking on more risk, I think that risk is likely to be rewarded in higher, longer-term returns—though still no free lunch.

I tell people who weren’t tilted to small cap value to stick to market cap weighting with boring, broad index funds like total stock and total international stock funds. However, I also think it’s dangerous to go back and forth chasing performance, which abandoning small cap value now would be doing. I do consider factor indexing an active strategy, but at least it can be done with low costs.

Allan Roth is the founder of Wealth Logic LLC, an hourly based financial planning firm. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for the Wall Street Journal, AARP and Financial Planning magazine. You can reach him at [email protected], or follow him on Twitter at Allan Roth (@Dull_Investing) · Twitter.

Allan Roth is founder of Wealth Logic, an hourly based financial planning and investment advisory firm. He also benchmarks portfolio performance for foundations and other business concerns. Roth's website is You can reach him at [email protected] or follow him on Twitter at Allan Roth (@Dull_Investing) · Twitter