Many investors take it as fact that small-cap stocks earn higher long-term returns than large-cap stocks, and that value stocks earn higher long-term returns than growth stocks. This belief originates with work by Fama and French on their 3-factor model of stock returns. The evidence that a small-cap premium exists is compelling, but not so for the value premium. Whether or not these premiums exist affects the choice of ETFs for an indexed portfolio.
John Bogle discusses growth vs. value stocks in the final third of an excellent speech in 2001. In it he observes that the Fama and French conclusions are based on stock market data from 1963 to 1990. It turns out that the size and even the existence of a value premium is period dependent.
Bogle extended the period of study to 1937-2000 and found the average annual compound returns to be 11.8% for growth stocks and 11.9% for value stocks, hardly a significant edge. You may ask what happened from 2001 to 2013. According to Standard and Poors, value stocks won by a little over half a percent per year. So, there was no statistically significant value premium in U.S. stocks from 1937 to 2013.
There certainly were periods where either value or growth stocks had a large advantage. However, unless an investor can predict whether a given future period will favour growth or value stocks, these swings are of no use.
Some might object that investors like Warren Buffett proved that value stocks are superior. This is a different situation altogether. Bogle, Fama, and French are comparing all value stocks to all growth stocks. But Buffett sought to own only those stocks he believed would outperform. Value investing through stock-picking is very different from an index strategy where the investor chooses to own all value stocks.
Implications for index ETF portfolios
In my own portfolio, I’ve chosen not to tilt toward either value stocks or growth stocks. I do have a modest tilt to small-cap stocks over large-cap stocks. I prefer Vanguard Canada’s fund VCN over the iShares fund XIU because VCN contains some small-cap stocks.
In the U.S., I prefer Vanguard’s VTI, which represents the entire U.S. stock market, over funds that hold just the S&P 500. In addition, I own some of Vanguard’s VB fund, which holds U.S. small caps, to add an extra small-cap tilt.
As always, I don’t think anyone should follow my choices blindly; think for yourself. That said, hopefully this discussion of how I bet my own money carries more weight than some pundit’s “investing ideas.” Comments and constructive criticism are most welcome. There is too much at stake when investing to ignore useful ideas.