Economists Eugene Fama and Ken French developed the three factor namesake model which predicted that portfolios tilted toward small cap and value over growth would result in higher long-term returns. Perhaps that’s why nearly every other index construction tends to outperform market capitalization weighted returns.
One way to harness the potential of small-cap tilting is to put clients into funds from the Dimensional Fund Advisors (DFA) family of funds -- with which both Fama and French are affiliated. Their low-cost value, small-cap and small-cap value funds have bested the overall market. Consumers can only get access to these funds through advisors.
But index funds constructed through methodologies other than market capitalization also harness small-cap value tilting. So-called “smart beta” fundamental index funds, using Rob Arnott’s Research Affiliates weighting methodologies, accomplishes this tilting. Offered through fund families like PowerShares, PIMCO, and most recently, Charles Schwab, these funds weight their stock holdings using cash flow, sales, book value and dividends. However the methodologies are not consistent across all fund families.
One downside of both the DFA and fundamental indexing approach is that it’s less tax-efficient since the funds turnover the stocks in their funds and pass the capital gains on to their shareholders. Buying an ultra-low-cost market capitalization weighted broad index fund and then supplementing it with small-cap and value funds from providers like DFA or Vanguard offers a more tax-efficient approach.
Now before deciding how much tilting is right for your client, it’s important to keep in mind that the Fama-French Three Factor Model stated that the extra return over a capitalization weighted index is not a free lunch. Rather than being a kink in the efficient market hypothesis, the extra return from this tilting is compensation for taking on more risk. Using Morningstar’s definition, small cap value represents about 3.3% of the stock market so caution is recommended in deciding how much to overweight.
Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes the Irrational Investor column for CBS MoneyWatch.com and is an adjunct instructor at the University of Denver.