Is there an efficient frontier for including smaller companies alongside an index fund?
aroominyork
Forumite 
The efficient frontier is usually discussed in equity/bond allocations, and says that although equities are higher risk than bonds, an 80/20 portfolio not only has better returns over time than 100% bonds, but carries lower risk. The shape of the frontier (the point of least risk) has varied in each decade over the last century, with the 80/20 curve representing an average picture.
Recently I invested about one-sixth of my US allocation in a US smaller companies fund, not to boost returns but to give me some diversification from the FANG-dominated index. I then wondered whether an 80/20 index/smaller companies equity allocation would provide lower overall risk than an 100% index fund.
For the US, UK, Europe and Japan I used Trustnet’s portfolio tool to combine:
- 80% of Fidelity index fund
- 20% of the smaller company fund which is the FE median in the sector over three years. For example, there were 21 funds in US smaller companies on a 3 year view; I then ordered them from high to low FE and selected number 11 in the list.
This is what I found.
US:
Fidelity US Index, FE87
Brown Advisory US Smaller Companies, FE131
80/20 portfolio, FE82
UK:
Fidelity UK Index, FE93
Premier Miton UK Smaller Companies, FE102
80/20 portfolio, FE88
Europe:
Fidelity Europe ex-UK Index, FE86
Schroder European Smaller Companies, FE97
80/20 portfolio, FE86
Japan:
Fidelity Japan Index, FE83
M&G Japanese Smaller Companies, FE110
80/20 portfolio, FE86
So this shows that for the US and UK, an 80/20 portfolio is lower risk than an Index fund.
For Europe, the risk is the same.
For Japan, the risk is a fraction higher.
It would take more work to look at performance since the
median risk smaller companies would not necessary deliver average/median
performance, but I thought I would post this and see what others make of it.
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Replies
Small cap has done relatively poorly compared to long term in the US due to the success of some very large companies. Even so, there's some benefit, showing up more over five years than three.
In performance order they are Light blue: ASI global smaller companies, green: ASI UK smaller companies, yellow: UT North America smaller companies, darker/brighter blue: UT North America, Brown: FTSE small cap ex investment co, Red: FTSE All share excluding investment co. The ASI funds are two that I've been using for many more than five years in a small cap heavy portfolio. Notice the considerably greater small cap benefit in the UK comparing yellow and brown with red.
Vs three years:
If you are looking for least risk, you should stick to bonds and definitely avoid small companies.
If you are looking for a level of risk that is acceptable to you, then there is no magic number. A risk that is acceptable to you will not be acceptable to another person.
Your post seems to make the false assumption that risk can be avoided by dividing your portfolio into certain ratios.
Reduced, not avoided. It's called diversification.