One of my Telegram group members started out investing in VWRD (Vanguard FTSE All-World UCITS ETF – (USD) Distributing) before shifting to QQQ (Invesco QQQ Trust). He soon realize that his portfolio would be mainly invested in large cap stocks, or stocks that are larger based on market capitalization.
Soon , he discovered about small cap stocks, and found it through exposure via AVUV (Avantis US Small Cap Value ETF).
Recently, he soon discovered that there is group of stocks that exist between them which is called the Mid-Cap stocks and wonder if it is important to have exposure to them. And if so should he tilt towards the quality, momentum or value factor.
Here is what I think.
Always Think About the Big Forces First.
We can get pretty caught up in considering whether to go with index-tracking investments or to go with a value, momentum or high profitability strategy.
But you got to remember that what will move the needle tends to be:
- Whether you are investing in equities over pure fixed income.
- Which region you invest in.
These are what I called the “big rocks”.
If you get caught up with all the other stuff, but only put 20% of your net wealth into the investment, you are really expecting your equities to do a hell lot of heavy lifting. The only way you can achieve an equivalent of a 100% equity portfolio outcome is that you push that 20% aggressively. Your results will be either very good or very bad.
I think if you ask me today what will do well in the future, I can’t tell you that mid-cap US stocks will do better than small-caps or large-caps.
Over short horizon like less than 10 years, there is equal chance of one doing better than the rest. Investors should have a time horizon of about 15 years or more just to break even with 100% equities. If you wish to have a higher probability of harvesting a decent return, you need about 20-23 years.
That sounds like a long time but that is the reality.
I pulled up some 10-year cumulative returns of US large-cap, mid-cap, small-cap stocks over the years in the chart below:
Stocks must have certain degree of liquidity, and be profitable for the previous quarters as well as the recent quarters.
From 1994 to today, we have about 31 years of data, and if we roll month by month we can have many 10-year periods. Each point on the chart represent a 10-year cumulative returns tarting from the date.
If you invest in a ETF that tracks the S&P 600 index in the mid of 2010, you would make a total of 117% in the next 10 years.
If you understand this chart, you would know that whether you invest in large, mid or small cap, your returns is not a fix 96% (7% a year) but that there are times when you earn less or more than this. I can’t tell you small caps or mid caps will do better because you see periods where they do much better than the large cap and also other wise.
I hope my reader doesn’t just focus on returns because if you invest today, you can only hope that you can get the better return. If you start in 2009, whichever you invest in, you get 438% 10 years later but if you invest at the peak of the Dot Com bubble, you earn -29% if you invest in the large cap but 42% otherwise.
I do think that mid cap have pretty close return to small cap in the past. There is so much less said about the mid cap stocks but you can see the returns tend to be among the best.
One interesting fact is that you realize the mid cap and small cap DID NOT have a negative 10-year period whereas we see that for the large cap.
In fact, since the reader invest in AVUV, my data work showed me that after 1930s, US small cap value don’t have a negative 10-year period. Not something I can say outright for the S&P 500.
The 1-Year Size Outperformance
I decide to do an excess return comparison for the different indexes:
The first chart shows the 1-year excess return if we take the return of the mid-cap minus the large. A positive number shows that mid-cap earn more than large cap over that one year period.
There were 174 positive and 188 negatives which means there were more years where S&P 500 did well.
Here is if we take the small-cap minus the large cap:
There were 179 positive and 183 negatives which means there were more years where S&P 500 did well.
And also taking small-cap minus the mid-cap:
There were 170 positive and 192 negatives which means there were more years where S&P 400 did well.
I think my reader would just go with the large cap at this point since there isn’t much difference.
The 5-Year Size Outperformance
The story is different if we extend to five years instead of just one year:
There were 185 positive and 129 negatives which means there were more years where S&P 400 did well.
You do see the recent outperformance of large cap but we can see the size outperformance.
Value, Profitability or Momentum Tilt?
I think a person who would like to have equities selection strategy needs to be align to a certain philosophy.
You can easily be rather fair weather and switch to another investment that supposedly perform better if you don’t have a clear philosophy. Of course, not everyone is interested in investing and you might not have one in the first place. If you trust someone, be it an adviser or a guru, you take a chance that this adviser’s or guru’s philosophy is the right investment philosophy.
Until the investments don’t perform and you realize this investment philosophy is shit. You proceed to find another one.
Nowadays, investors are divided into a few camps:
- The trust the market and no matter what happens, I buy and hold an index. They probably see the past 10-12% p.a. returns and the returns make them convicted to just index.
- You think that there are stocks that exhibit strong momentum, and when the momentum wanes, you switch from stocks with weak momentum to strong momentum.
- You don’t like to buy stocks that are expensive, and would follow the traditional Buffett way of buying cheap companies. If you are patient and when the companies move towards their intrinsic value (hopefully it is higher), you will sell them off. Rinse and repeat.
- You think stocks should not be judge based on price. Quality matters too. And Buffett have shown that if you buy quality businesses at reasonable prices, you will do well.
Different philosophies but do they work?
The evidences seem to suggest all of them would help build wealth IF you have a long time horizon (see my first point in this article). The research shows that there is a premium to be earn if you do #2-#4 much higher than 1.
But you might have not read that much and so you find #2-#4 to be bull crap. The data in the past 5 years shows that I am wrong or these research is wrong.
Well, that is your investment philosophy then (for now).
I am not going to convince my reader to tilt to what momentum, value or quality.
But if you came from the individual stock investing world and you can’t bring yourself to own expensive stuff, then you have a investment philosophy towards value.
So you can express that investment philosophy by buy large, mid or small cap value.
So only my reader can answer his own question.
But I really hope people can try their best to get past just looking at “this strategy in the past show higher returns” kind of analysis to deduce this is a better strategy and suitable for you. This is because US vs international vs emerging market, small vs large, value versus growth, the returns of these comparison is not consistent throughout time, and places.
If someone don’t seek to figure out what drives the premiums fundamentally, they might be deeply disappointed if they place their decision solely on returns. Very often, we will see people just chase investment after investment when their existing investment doesn’t work until the person gets rather dispirited.
If you like this stuff and wanna tap into my money brain, do join my Telegram channel.
I share what I come across in:
- individual stock investing
- wealth-building strategies
- portfolio management
- personal finance, financial independence.
I would also share some of the thoughts of wealth advisory, financial planning and the industry that I don’t wanna put out on the blog.
Would probably share some life planning case studies based on the things I hear or came across as well.
Kyith is the Owner and Sole Writer behind Investment Moats. Readers tune in to Investment Moats to learn and build stronger, firmer wealth foundations, how to have a Passive investment strategy, know more about investing in REITs and the nuts and bolts of Active Investing.
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Kyith worked as an IT operations engineer from 2004 to 2019. Currently, he works as a Senior Solutions Specialist in Insurance Start-up Havend. All opinions on Investment Moats are his own and does not represent the views of Providend.
You can view Kyith’s current portfolio here, which uses his Free Google Stock Portfolio Tracker.
His investment broker of choice is Interactive Brokers, which allows him to invest in securities from different exchanges all over the world, at very low commission rates, without custodian fees, near spot currency rates.
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