Small-Cap Value Funds are part of a diversified portfolio for a very important reason – this article attempts to illustrate what Small Cap Value funds are and their importance in your portfolio.

First, let’s discuss the Cap reference.  Cap is derived from the term market capitalization which is the market’s estimated value of the total company’s public stock. Stocks are classified into several levels of market capitalization – generally:  Small, Mid, and Large.  Small-cap stocks are shares of companies where the total market value ranges between $300 million to $2 billion while Large-cap stocks are shares of companies where the total market value range is greater than $10 billion and Medium-cap shares are in between at $2 billion to $10 billion.

Generally, company stocks can be further categorized between value and growth.  A “value stock” is believed to be at a lower price than its true worth, while a “growth stock” is believed to have significantly higher potential growth earnings in the future.  Essentially, value investors target currently undervalued companies while growth investors are less concerned over the price they pay for the stocks as they expect the stocks will increase in value at some in the future.  The value stocks are usually considered undervalued based on metrics like price-to-earning (compares a company’s share price with its earnings per share) and price-to-book (compares a company’s market value to its book value per share) ratios.

Small-cap value (SCV) funds are therefore mutual funds or exchange-traded funds (ETFs) that are formed with the purpose of investing in small-cap companies with attractive valuations. Essentially, SCV funds are groups of small, undervalued company stocks. The types of companies that tend to make up these funds are companies with strong fundamentals, like stable cash flows or high returns on equity, but are undervalued in the market[1].

Small-cap stocks are generally more volatile than large-cap stocks. It takes less trading volume for small-cap share prices to move up and down, so it is common to see them fluctuate more than large-cap shares. Having hundreds or even thousands of stocks in the SCV funds diversifies the portfolio and mitigates some of the risks associated with small-cap stocks.

SCV Funds also provide exposure to industries that are under-represented in large-cap funds. This gives investors opportunities to diversify and develop a well-rounded portfolio.

SCV funds focus on companies that may have a lot of room for growth and expansion. Because SCV funds tend to fluctuate more than the market and the underlying stocks are often considered undervalued, investors can buy “at a discount” without attempting to time the market. As of 2024, SCV funds continued to be valued attractively compared to large-cap growth funds.

Though we have mainly addressed SCV investing in US stocks thus far, the same can be said for SCV in international stocks.

What Makes SCV Funds Different?

Many investors follow the S&P 500 and invest accordingly in large-cap funds. What is unique about SCV funds is that they can at times go against market trends. This means these smaller companies have room for growth as the market sentiments shift.

Even within the realm of SCV funds, not all funds are the same. While some funds are indexed, others are more actively managed. A financial advisor can review the different funds and help you determine which investment may be the appropriate addition to your diverse portfolio.

Why Consider Incorporating SCV Funds in Your Portfolio?

Small-cap and Value have historically outperformed Large-cap and Growth over long periods of time, but not always. Though we know SCV funds can be more volatile than funds in the short term, their performance over time shows that they have worth. These types of funds are an option that can be used to work alongside other types of investments to fill out a healthy, well-rounded portfolio.

If you incorporate these funds into your portfolio, you must be patient and ride out the periods of underperformance to reap the returns from these funds. The longer you hold these funds through the ups and downs in the market, the more likely they are to grow and give you a higher return on your investment.

Take the following statistics for example. Reading the bar graph below, you can see that in a one-year period, small-cap beat large-cap funds slightly more often than not (55% of the time), and Value also beat Growth on average more often than not (59% of the time). Those percentages jump up to 59% and 70% respectively when looked at over a five-year period and jump all the way up to 68% and 78% when considered over a ten-year period.  This isn’t guaranteed, however. Keep in mind that the opposite is also true – for example: in 32% of ten-year timeframes, large-cap outperformed small-cap. SCV funds tend to bounce back faster during tough market cycles, as under-valued stocks regain fair value over time. Keep in mind that these are general historical market observations and not a guarantee of performance.

Additionally, if you look at the graph below comparing an Small Cap Value Fund (DFSVX) with a large-cap (S&P 500) Fund (SPY), you’ll see that the large-cap Fund is very close for the first few years. As time moves on, you’ll see the differences in performance between the two. There are a few more dips and more severe downturns in performance for the SCV Fund, but both funds are trending upward overall, with the SCV Fund outperforming the large-cap Fund in the end over time. Keep in mind that the graph shows a time period of almost 30 years. Investing in SCV Funds is not a get-rich-quick scheme. It can be one piece of a well-diversified portfolio and carefully considered with your financial planner as a long-term investment option with appropriate risk tolerance.

Remember, diversifying your portfolio isn’t just about choosing funds that give the best returns. It is also important to consider rebalancing your funds as well– selling some of the asset class that went up to capture the gains and buying some of the asset class that went down when their price is lower – all according to your investment strategy.

The goal mindset when considering investing in an SCV fund is long-term wealth creation. They may be a good option for long-term investors who are less concerned with short-term loss or profit and who have other investment strategies in place to balance their portfolio.

Are SCV Funds a Good Option for You?

Like any investment conversation, there is no “right” answer. You should always consult your financial planner to decide what is best for your financial future. Small-cap value funds are a great way to diversify your investments, in addition to other investment strategies, to create a healthy, well-rounded portfolio. Should you decide to invest in SCV funds, remember to be patient. Do not panic when the market goes down. Keep in mind that as with any investment opportunity, there is risk, and SCV Funds have also had stretches of underperformance.

The above is for informational purposes only and is not to be taken as advice. Please talk to your Fee-only Certified Financial Planner TM Professional before making any investment decisions.

 

 

[1] https://www.investopedia.com/terms/s/small-cap.asp