Small cap diversifier in portfolio

Pat38493

What are the thoughts of the hive mind on holding a portion of small cap funds in the equity part of the portfolio as a diversifier?

I've seen some IFAs like that James Shack guy and a few others imply that they often use a portion (maybe up to 30%) of small cap as this seemed to provide a higher SWR / higher success rate, than just going with straight up global trackers.  I did a few tests and it seemed to bear this out - the historical success probability is up by about 5% if you were carrying about 20-30% of small cap, versus carrying only global trackers or large cap trackers.

On the other hand, this effect didn't seem to be the case in the last 20 years or so, so the effect is based on very long term patterns.

The second question would be - opinions on using active funds instead of passive for small cap?  Some have claimed that the benefit of using active management on small cap is greater - what do you all think?

tacpot12

I tend to think that active management should be better for small caps, but its important to realise that the data about small caps is going to reflect the entire small caps market in a geopraphic area (which you can invest in passively) rather than particular small caps fund, so you can achieve what you want to using passive investments. 

I have a small caps holding in my retirement portfolio, but it's only about 5% of the portfolio. I don't have the confidence to invest more than that percentage, given I can acheive my aims with the portfolio I have (It's been running for five years or so). 

gm0

I'd suggest thinking about risk and portfolio shape/volatility more than better total returns. 
I don't see an objection to passive indexers for "small(er) cap".  For EM/frontier - arguments re active are more germaine around small, state influenced markets and local knowledge.

When coming up with my retirement asset allocation I decided that I would extend equities diversification to both Small Cap and EM (beyond global developed markets trackers).  It was what I believed in about pragmatic risk reduction in deaccumulation investing based on my reading up to that point.   I am not disabused of the thinking behind the investment statement.  But a total returns premium was not the objective or expectation.  Adequate returns at reduced volatility and concentration risk - was.

Overall wanting to invest fairly aggressively in equities (to 70-80% overall) but not be sucked ever deeper into a concentration on US large cap and tech.  So looking for options for additional equity investments. 
Objective being enough return, "damping" of volatility to a degree and ideally reduced sensitivity to perceived concentration

This is of course an active stance in itself.  Albeit one built out of passive funds.  A mean reversion bet against US growth/tech.  Too soon to tell at 2.5 years.  Ask me 2-3 years after the next major market revaluation and subsequent rally.  But to date.  Not better.  Dampened possibly.  Less concentrated certainly.  Lower returns - definitely - see below.

I decided to not bother with much less than 5% of anything.  So that the impact of adding a fund would begin to become material for the complexity so added.  

Longer backtesting (trustnet) does indeed suggest that within asset class extensions will dampen the portfolio volatilty vs alternatives under consideration I tested on the same data set

To date holding the extra funds has "robbed" about half the available total return versus a simpler large cap global tracker approach on that element of the portfolio on the same platform and that fund selection. 

So in that sense - bad idea - or still a good idea - poorly timed.  Or a weak fund offer even though passive.  Or it will do what I wanted long term - but the lost total returns foregone premium was and is high in this period.  Too soon to say.

Here worked example data from one of my platforms used in deaccumualtion.  All LGIM passives.

30 months or so. Feb22 to date. Growth.  After income

Small cap equity index 9.3%
World ex UK Developed Equity Index 17.5%
UK equity index 18%
EM equity 10%
Multi-asset 3  9.9%

Is this good or bad.  Objectively bad (but not terrible)
But is it doing what is needed and is it behaving as expected.

Overall 8%. 
But net of income taken and costs. 
So 16% "returns" with the income back in.
Closer to notionally "keeping up". CPI is ~15.5% for that period (first pass from web). 

On portfolio value point in time metric a "natural yield" maintain the portfolio AND its real value approach would be a portfolio value of 15.5% above start value net of all income today.  Just start value CPI indexed.

A 40 year capital depletion chunks + returns drawdown plan -  would imply more like 12.3% over start value now.

I am at 8% (for this portfolio section).  Not great. Not truly awful. 

I think it stil (just about) passes my "avoid bad DIY" objective test as part of the overall shape.

I have perhaps taken about a 4-5% real value beating from the inflation spike and accompanying bond journey.  I know from forum pain - others have fared worse.  I wasn't setup "correctly" in good time.  But neither did I make a major ill timed investment decision around it.

For contrast - for the same dates - my best occupational low cost global "tracker" fund which is also LGIM (Global 1500 stocks, ethical knockouts). Has done 31.7% in the same period. 
Kicking World Developed ex UK + UK into the weeds with its pitiful 18%

But that one contains a fruity - 25% MSFT, APPLE and NVIDIA and Alphabet from a recent factsheet top 20.

Not the same risk profile as the above.  At all.

Risk mix.  Not returns premium.

Bostonerimus1

30% in small cap is going to greatly increase the volatility of a portfolio. If you are young you might be able to deal with that, but older pension investors will want to look at the potential increase in sequence of returns risk. Personally I see no reason to overweight any particular sector and so stick with cap weighted global indexes. Doing that saves a lot of anxiety. If you are talking about actively managed small cap keep "Woodford" in your mind. 

FYI my simple 90% global equities and 10% income fund portfolio has a 10% average annual return since I retired in 2014. Before that I was 60% global equities and 40% US bonds and from 1992 to 2014 that returned ~8% average annual return. Just plug long term returns like those into a compound interest calculator and see how many zeros are in the results. I don't see a need to complicate things.

Pat38493

Bostonerimus1 said:

30% in small cap is going to greatly increase the volatility of a portfolio. If you are young you might be able to deal with that, but older pension investors will want to look at the potential increase in sequence of returns risk. Personally I see no reason to overweight any particular sector and so stick with cap weighted global indexes. Doing that saves a lot of anxiety. If you are talking about actively managed small cap keep "Woodford" in your mind. 

FYI my simple 90% global equities and 10% income fund portfolio has a 10% average annual return since I retired in 2014. Before that I was 60% global equities and 40% US bonds and from 1992 to 2014 that returned ~8% average annual return. Just plug long term returns like those into a compound interest calculator and see how many zeros are in the results. I don't see a need to complicate things.

Yes - but historical back testing seems to show that actually the sequence of return risk (at least in terms of the number of failed scenarios on a long term spending profile), actually was reduced by about 5% after increasing the small cap percent.

I have to admit I'm not sure why that is, since there is no reason to think that small cap would not be impacted by major market events in the same way as large cap equities and seems to be more volatile.

If the reason is that there were historical periods when small cap grew faster over the long term than large cap, and this mitigated some of the market crash situations, the issue there is that over the last 20 years, it appears that small cap had all the downside of increased volatility without the upside of extra growth.

That said, if you think that historical simulations of the last 120 years or so have any value, I guess you should not ignore the results just because some of the scenarios are older than others.

Also just to be clear, I did not mean 30% of the overall portfolio in Small cap - I meant 30% of the equity part, so for example if you are on 70/20, that would end up at about 20% overall.  gm0 is correct that over the last couple of decades, with hindsight, this certainly would have not been the best strategy.

Bostonerimus1

Even 30% of equity as Small Cap is vastly overweighting Small Cap. I can see how the greater growth of Small Cap over Large Cap or a general equity index could improve the results of a backtested retirement portfolio, but the volatility might make it a bit of a white knuckle ride.

Albermarle

Just to throw another idea in the ring is that you can invest in Mid Caps.
iwsz-ishares-edge-msci-world-size-factor-ucits-etf-fund-fact-sheet-en-gb (fundslibrary.co.uk)

Less US orientated than the usual global index and no Big Tech.
It has grown only 50% of VWRP in the last 5 years, but you could hope it would not drop so quick in the face of a US/big tech meltdown. 

leosayer

I did hold a 10% small cap equity index fund for a while but stopped once I realised that small caps are already covered in Vanguard FTSE Global All-Cap Index in the following proportions, according to the thread linked below.

Large Cap 67.78%
Medium/Large Cap 4.28%
Medium Cap 14.35%
Medium/Small Cap 6.48%
Small Cap 6.94%

I had watched a few YouTube videos from Ben Felix talking about the positives and negatives of holding small caps and I decided to stick with simplicity in the ones fund seeing as I had exposure I was happy with.

Pat38493

leosayer said:

I did hold a 10% small cap equity index fund for a while but stopped once I realised that small caps are already covered in Vanguard FTSE Global All-Cap Index in the following proportions, according to the thread linked below.

Large Cap 67.78%
Medium/Large Cap 4.28%
Medium Cap 14.35%
Medium/Small Cap 6.48%
Small Cap 6.94%

I had watched a few YouTube videos from Ben Felix talking about the positives and negatives of holding small caps and I decided to stick with simplicity in the ones fund seeing as I had exposure I was happy with.

Thanks yes good point and I am aware about the Vanguard fund.  I am holding some of that fund, but I'm also holding an HSBC global tracker ETF that has no small cap in it at all (probably explains why it has done better the last decade), mainly because I invested in them at different times with different knowledge levels but they are very similar and have overlap.

Pat38493

Albermarle said:

Just to throw another idea in the ring is that you can invest in Mid Caps.
iwsz-ishares-edge-msci-world-size-factor-ucits-etf-fund-fact-sheet-en-gb (fundslibrary.co.uk)

Less US orientated than the usual global index and no Big Tech.
It has grown only 50% of VWRP in the last 5 years, but you could hope it would not drop so quick in the face of a US/big tech meltdown. 

Thanks I was not really aware of that type of fund.

gm0

@Albermarle - what do they say - "hope is not a strategy". 

But still interesting - for those exploring this form of asset allocation and extension with a long term pov.

In fact this etf pushes several top down design buttons for "equities" say in a Fidelity ETF based portfolio (ISA/SIPP)

Positives: 

Physical replication (always preferred).  I don't do synthetic anything.  Unwanted concentrated extra counterparty risk category for derivatives. Can avoid.  Do avoid.  Absent a compelling reason to want one.

Equal weight.  Unobjectionable. Not particularly the point today.

Cost is about par for what you get at 0.3%

Possible "negatives":

A smaller fund size AUM $200m - not planning on trading in a crisis.  But it is a comparator nonetheless
FX - USD base puts it in the same GBP/USD FX impacts on returns space as many other ETFs run the same

A trip to trustnet

An equities holding as part of a total portfolio - scenario: 90% Vanguard Dev World ex UK. 10% IWCS
Comparator being "the portfolio" vs don't bother and just use the Dev World fund

90/10 Portfolio Volatility 11.84	Alpha 4.64	Beta 0.72	Sharpe 0.42

Versus not bothering the Dev World ex UK fund) greeks are:

Dev World ex UK Fund Volatility 11.78	Alpha 4.47	Beta 1.00	Sharp 0.51

You would not expect a huge difference.  And you don't get one.  Volatility slightly up .  Sharpe down.

But the Beta of the portfolio is also down vs the single large cap fund - perhaps reflecting the possible defensive impact of the approach

As discussed in the thread above - it may be a possible choice - despite the negative recent "past performance over 3 to 5 view" - aiming at very long term within asset class diversification.  There isn't trustnet data on IWCS back past 5 years so not possible to extend that analysis very far.  How it behaves across the "major events" is actually the more interesting element from a retirement planning/deaccumulation perspective