Ben Felix - The Problem With Small Cap Stocks

Short Summary

Main recommendation: DIY investors should be cautious about buying broad small cap ETFs expecting to capture the size premium, because the premium largely disappears in typical small cap indexes once small cap growth, low profitability stocks are included. Ben Felix argues that most DIY investors are likely to have the best long-term investment experience using low-cost, broadly diversified, market-cap-weighted ETFs.

Key Points

• The size premium (small caps outperforming large caps) was first documented by Rolf Banz in 1981, using data from 1936 to 1975, but recreating the study with today's data shows it was only significant at the 10% level, not the usual 5%.
• Delisting bias corrected by Tyler Shumway's 1997 paper, "The Delisting Bias in CRSP Data," made small cap returns look worse, since delistings were mostly negative events for smaller companies.
• Much of the size effect is concentrated in the smallest stocks, which are expensive to trade for index funds, making implementation difficult.
• Small cap growth stocks with low profitability drive the underperformance; removing them revives the size premium, which then becomes consistent, geographically broader, and statistically significant.
• Common broad small cap ETFs, such as XSU (Russell 2000) and XCS (S&P/TSX small cap), include these low-profitability growth stocks and underperformed their benchmarks or the total market in the periods cited.

Details Worth Noting

• Concrete instructions: Do not buy a broad small cap ETF expecting the size premium by default. If you want small cap exposure, look for funds that screen out small cap growth, low profitability stocks, but note that DIY investors typically cannot access the best such funds (e.g., DFA). Compare any small cap fund against a cheap total market ETF, such as XUU (MER 0.07%), before adding it, since XSU carries a 0.36% MER. For most DIY investors, the video recommends a low-cost, broadly diversified, market-cap-weighted ETF as the default.
• From 1979 to 2017, the Russell 2000 returned 11.73% per year versus 14.37% for the Dimensional US small cap index and 11.95% for the Russell 3000.
• From 1975 to 2017, US small caps returned 14.93% per year, rising to 16.5% after removing small growth, low profitability stocks.
• Canadian comparison: from February 2000 to 2017, the S&P/TSX small cap index returned 5.03% per year, the Dimensional Canada Small Cap Index returned 9.97%, and the S&P/TSX Composite returned 6.28%.
• Vanguard's VBR is a small cap value fund with no small cap growth exposure, so it is more attractive than broad small cap funds, but its average company size (about $3.6 billion versus $1.8 billion for the DFA fund) and value exposure (price-to-book 1.87 versus 1.32) are less pronounced. From January 2000 to December 2017, the DFA fund beat Vanguard's by about 54 basis points per year after fees.
• Smaller companies and deeper value carry more risk; the DFA fund's higher expected returns come from intentionally taking more of these risks. DIY investors typically cannot access DFA funds.

Bottom Line

Small cap exposure is only worth pursuing if it is structured to exclude low-profitability growth stocks, which most accessible DIY small cap ETFs do not do, so for most investors a low-cost total market approach is the simpler choice.