Some small-caps win in the long term — but which ones?

Value pays off when it comes to investing in small-cap funds

By John Waggoner

May 31, 2018 @ 6:59 pm EST

Many things work better in theory than in practice. For example, it's theoretically good to run five miles a day, provided you don't blow out your hamstring or get eaten by a bear. And in theory it's good to invest in small-company stocks for the long term. But the type of small-cap fund you choose makes a big difference — and in most cases, your best bet will be an index fund.

Most advisers are familiar with the Ibbotson chart showing that small-company stocks have outperformed their large-cap brethren by about two percentage points a year since 1926. The long-term outperformance of small-company stocks makes some sense: It's a lot easier for a $1 billion company to double its market capitalization than a $100 billion company.

Theory and practice don't always intersect, though. Over the past 30 years, the Russell 1000 large-company stock index has gained an average 10.55% a year, according to Morningstar. In contrast, the Russell 2000 small-company stock index has gained an average 9.76% a year. (Both figures include reinvested dividends.)

A value tilt to the small-cap index, however, has proven to be a winning combination: The Russell 2000 small-cap value index has gained an average 10.76% a year since 1988. This makes some sense: There are far more small-cap companies than large-cap ones.

"The small-cap universe has more underfollowed companies than large-cap growth stocks," said Todd Rosenbluth, senior director of ETF and mutual fund research at CFRA. "Managers can find companies with strong fundamentals that are hidden gems."

Unfortunately, finding a small-cap value fund that will continue to beat the index is daunting. According to Standard and Poor's, 95.45% of all small-cap value have lagged their benchmark index the past five years. One reason, shared by all value strategies, is that an undiscovered gem could turn out to be an undiscovered pile of manure, Mr. Rosenbluth said.

And many of the small-cap value funds with spectacular records over the past 30 years haven't gone unnoticed. This, too, is a problem. Most funds are reluctant to own more than 5% of a company's outstanding stock. The larger the fund, the greater the number of holdings the fund must have — and that can make it hard for a manager to meaningfully diverge from the index.

As a result, many small-company value funds close to new investors when they get too large. Others merge or liquidate. Over the past 15 years, just 62.11% of all small-cap value funds have survived, according to S&P. Morningstar's database lists eight funds that have been around for 30 years.

Some of those eight funds are corkers. Janus Henderson Small Cap Value (JDSAX), for example, has gained 11.9% a year over the past 30 years. Along the way, it's gained quite a bit of weight, too: The fund now has $2.9 billion in assets spread among 80 holdings, and the average market cap of its holdings is higher than its benchmark index.

As good as the fund has been for the past 30 years, one could argue that its size may be an impediment going forward. You could look for small, actively managed small-cap value funds with good track records, such as the $130 million CornerCap Small-Cap Value Fund (CSCVX), which is up 13.16% a year for the past five years, or the $201 million Goldman Sachs Small Cap Value Insights Fund (GSITX), up 11.86% a year for the past five years.

Given the bleak history of long-term outperformance in the category, however, a more practical approach may be to buy a small-cap index ETF with relatively low assets, such as Vanguard S&P Small-Cap 600 Value Index Fund ETF (VIOV), which weighs in at just $339 million.

Would you beat the best small-cap fund over the next 10 years or more? Nope. On the other hand, you'd get the advantage of lower expenses: The Vanguard offering charges just 0.20% a year, vs. 1.30% for the CornerCap fund and 0.84% for the Goldman Sachs fund. While many things are good in theory, combining small cap, value and low expenses seems to work well in practice.

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