While market-cap weighted index funds are an excellent starting point, adding exposure to specific risk factors can improve a portfolio’s long-term reliability.
The Limits of Market-Cap Weighting
The standard advice for the sensible investor is to buy low-cost, market-cap weighted index funds. It is advice I have given many times, and I still believe it is the right path for the majority of people. However, there is a nuance to my own investment strategy that I rarely discuss: I do not invest my own money exclusively in market-cap weighted funds. While I am an index investor, I recognize that market-cap weighting—where the weight of each company in your fund matches its weight in the total market—has inherent limitations.
When you buy a total market index, you are essentially buying a portfolio dominated by large-cap stocks. By definition, the biggest companies take up the most space. This results in an even mix of 'value' stocks (those with low prices relative to book value or earnings) and 'growth' stocks (those with high prices relative to those metrics). While there is nothing inherently wrong with this balance, decades of financial research suggest that certain subsets of the market—specifically small-cap and value stocks—are expected to outperform over the long term.
From CAPM to the Three-Factor Model
To understand why small-cap and value stocks matter, we have to look at how we price assets. In the 1960s, the prevailing theory was the Capital Asset Pricing Model (CAPM). This model suggested that a portfolio’s return was dictated by a single factor: market beta, or its sensitivity to the overall market's movements. Under CAPM, if a portfolio returned more than the market, it was assumed the manager had a special 'alpha'—the ability to pick winning stocks or time the market. However, CAPM only explained about two-thirds of the difference in returns between diversified portfolios.
The model began to crack in the 1980s when researchers like Rolf Banz and Barr Rosenberg found that small stocks and stocks with high book-to-market ratios (value stocks) consistently delivered higher returns than their market beta could explain. Initially, this looked like a market inefficiency. But in 1992, Eugene Fama and Kenneth French reframed these findings. They argued that the market was still efficient, but that our model was too simple. They proposed a three-factor model that added 'size' and 'relative price' as independent risks. By accounting for these, they could explain 90% of the difference in returns between portfolios.
The Reality of Risk Premiums
It is vital to understand that these extra returns are not a 'free lunch.' In an efficient market, higher expected returns are always related to higher risk. Small-cap and value stocks are riskier in specific, documented ways that are independent of the general market's ups and downs. When you tilt your portfolio toward these factors, you are choosing to bear those specific risks in exchange for a historical premium. In the US, from 1926 through 2018, the market premium averaged 6.28% per year. During that same period, the size premium (Small Minus Big) was 1.88%, and the value premium (High Minus Low) was 3.78%.
Critics often suggest that these premiums are the result of 'data mining'—finding patterns in US data that don't exist elsewhere. However, global data tells a similar story. While the size premium can be thin in certain international markets, the value premium has remained robust and positive across nearly every geography studied. These factors are not just off-the-cuff observations; they are fundamental pillars of modern financial science.
Persistence and the Pain of the Present
Investors often grow skeptical of factor investing during periods when small-cap and value stocks underperform, as they have for much of the last decade. But we must view persistence through a wide lens. If we look at rolling ten-year periods in the US, the market risk premium has been positive 85% of the time. Remarkably, the value premium has been positive 84% of the time. This means that, historically, value stocks have been just as likely to beat growth stocks as the total stock market has been to beat a risk-free asset like treasury bills.
The recent decade of growth-stock dominance is not a reason to abandon the strategy. Just as the total market can go through long periods of stagnation, individual factors can underperform for years. If you believe in the market risk premium—the idea that stocks will outperform cash over time because they are riskier—you should logically believe in the size and value premiums for the same reason. They are all based on the same underlying principle: that markets accurately price risk.
Practical Implementation for the DIY Investor
For many people, the simplicity of a single, total-market fund is the best recipe for success because it prevents the urge to tinker. However, for those already 'slicing and dicing' their portfolios for tax efficiency or cost, adding a factor tilt can increase diversification and expected returns. To get exposure to these independent risks, you must own small-cap and value stocks in weights higher than they exist in the general market. This usually involves adding specific 'Small Cap Value' ETFs to a core market-cap weighted holding.
In my own research, adding these tilts to a model portfolio has historically improved 20-year performance and decreased standard deviation. It is about building a portfolio that is more statistically reliable. While I use specialized institutional funds for my own investments, the same principles can be applied by any DIY investor using low-cost ETFs. The goal isn't to beat the market through luck, but to capture the diverse range of risks that the market offers to those willing to hold them.