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Beat the market (Part 2: electric boogaloo)

  • 6-min read

Our second installment in our series on historically well-performing investment strategies: The Small-Cap Value Tilt. Buckle up.

CBS / Giphy

This story is part of a series that analyzes investing strategies that have historically outperformed a specific index. Past results are no guarantee of future results, and this information is not to be construed as investment advice. Also, take your vitamins.

Recently, my portfolio has been hemorrhaging money as the S&P 500 continues its freefall into the valley of despair. Unlike the 2020 Covid-induced crash, I can’t rely on J-Pow and the Plunge Protection Team hitting the turbo button on the Fed money printer again to save the market. Still, I’m not capitulating.

Last time, we discussed how a 1.5x leveraged portfolio of 40% stocks and 60% Treasury bonds has historically beaten the market on a risk-adjusted basis. If you despise using leverage or if bonds give you the ick, here’s an alternative strategy.

So what’s the strategy?

Let’s call it The Small-Cap Value Tilt. It’s all about overweighting the proportion of small-cap value stocks in your portfolio beyond normal market cap weights. Fair warning: There’s a bit of math ahead, so dig out your TI-84. 

CAPM & Fama-French factor investing

The Capital Asset Pricing Model (CAPM) helps investors calculate the expected return of an asset based on its risk:

​Ke ​= Rf​ + βp * ​(Erm​ − Rf​)


  • Ke​ = expected return of investment
  • Rf​ = risk-free rate
  • βp​ = beta of the investment
  • (Erm​−Rf​) = market risk premium​

In words, CAPM states that the expected return of an investment (such as stock) is a function of its risk-free rate (Treasury bills), plus its beta (volatility relative to the market), multiplied by the market risk premium (the return expected from the market above the risk-free rate).

So CAPM explains market beta and how exposure to this risk factor grants you an equity premium. But some sources of alpha (excess risk-adjusted returns over the market’s average) just couldn’t be explained by CAPM. 

… until the 1990s, when Eugene Fama and Kenneth French identified additional risk factors. The pair came up with a 3-factor model, which was later expanded to a 5-factor model. We’ll focus on just two:

  1. The size premium: Returns of small-cap stocks minus the returns of large-cap stocks. It is expressed as Small minus Big or SmB
  2. The value premium: Returns of high-book-value stocks minus the returns of low-book-value stocks. It is expressed as High minus Low or HmL

Small-cap stocks’ historical performance

Small-cap stocks have market capitalizations (share price ✕ number of shares outstanding) between $300 million and $2 billion. 

Small-caps are riskier, and in line with the Fama-French model, investors buying them tend to be rewarded with higher returns. Below I’ve backtested two portfolios. The first is 100% total U.S. stock market, and the second is 100% U.S. small-cap stocks.

The portfolio growth of the method discussed from 1972 to 2022.
Tony Dong & Portfolio Visualizer

Notice how the small-cap stocks had an overall higher return despite more volatility. Overall, the risk-return profiles of both portfolios were similar. However, an investor in the small-cap portfolio would have made significantly more money over the entire period.

Value stocks’ historical performance

Value stocks appear to trade at a lower share price relative to their fundamentals.

Like with small caps, investors are generally rewarded with a higher return for taking on the greater risk of value stocks. A 1995 research paper found that when value stocks beat earnings, they tend to skyrocket; when they don’t, they fall significantly less than growth stocks (case in point, check out what recently happened to Netflix, the now-tainted darling of growth stocks). 

I’ve backtested two portfolios below. The first is 100% total U.S. stock market, and the second is U.S. large-cap value stocks.

The portfolio growth of the method discussed from 1972 to 2022.
Tony Dong & Portfolio Visualizer

We see how value stocks have also significantly outperformed both in terms of total and risk-adjusted returns. An investor who held on to value stocks, despite growth outperforming over the last decade, would have been rewarded handsomely. 

Small-cap value stocks’ historical performance

According to the Fama-French model, combining different risk factors can help investors supercharge their returns. A very common and potentially profitable combination is small-cap value. To quote Cliff Asness’s research from AQR Capital: “Size matters, if you control your junk.”

Once again, I backtested two portfolios. The first is 100% total U.S. stock market, and the second is U.S. small-cap value stocks.

The portfolio growth of the method discussed from 1972 to 2022.
Tony Dong & Portfolio Visualizer

We see even greater outperformance compared to just small-cap or value stocks in isolation. The small-cap value portfolio has a much higher overall and risk-adjusted return.

But I could just invest in an index fund, right?

Yes, and you would statistically do better than the majority of retail investors out there with minimal costs, efforts, or stress. A small-cap value tilt is relatively simple to implement (especially with ETFs), but it’s incredibly difficult to stick with.

There have been extended periods of time where the size and value risk factors have delivered negative returns (that is, large-cap and growth stocks beat their counterparts). Even the market beta risk factor has historically delivered negative returns (as evidenced by periods when treasury bills beat stocks).

Check out this backtest of annual returns. Over the recent decade, small-cap value underperformed large-cap growth thanks to the boom of U.S. tech sector giants like Alphabet, Apple, and Microsoft. The trend seems to be reversing in recent years, though.

The annual returns of the method discussed from 1972 to 2022.
Tony Dong & Portfolio Visualizer

The real problem here is behavioral finance: the fear of missing out. It’s hard to stick to a small-cap value tilt when you’re underperforming the S&P 500 and TikTok investors are dancing to “About Damn Time” while they tell you about their 300% returns on GameStop options.

Plus, a small-cap value tilt takes significant time to return a premium. Investors who don’t trust the math and remain rational will likely capitulate during periods of underperformance, ruining their chances at beating the market. If you implement this strategy, you must be aware of recency bias and avoid performance chasing. (This clip from “Bird Box” sums it up.)

Should I tilt or should I go?

Now, The Clash didn’t exactly sing that, but in an alternate universe where they managed a hedge fund, they might have.

Strategies like this one require a good deal of cold-blooded rationality, conviction in the math underlying the theory, and a zen-like detachment from market noise. If you’re absolutely set on trying it, ensure you do your own independent research, consult dissenting opinions, and risk only what you can afford to lose.