Investing Basics: Small cap value ETFs – why they have a reputation for beating the market

There’s a small corner of the stock market that looks promising for four reasons: 

• It can beat global equities (and has done historically)
• It diversifies away from tech stocks — useful if you’re concerned about overexposure to this sector
• It diversifies away from large cap stocks — useful if you’re worried about signs of overvaluation in the US
• Is backed by compelling research and evidence

 This stock market subset is called small cap value, or small value if you’re in a hurry.

The small value bucket is filled by stocks that: 

• Have a low total value in comparison to the overall market. (This is the small cap part.)
• Are cheap at the price when measured by industry-standard valuation metrics. (This is the value part.)

In short, these are small companies that look like a bargain.

Small cap value versus the market

 There is solid evidence that small cap value can actually beat the market.

US small value registered a convincing win over the S&P 500 from 1999 to 2024:

US Small Cap vs. S&P 500 (1999-2024)

US small value beat the S&P 500 by 39 % over the past 26 years, according to Vanguard fund data.

Small value’s win is even more decisive outside the US:

International ex-US small cap value beat Global ex-US by 99 % over 28 years.

That’s an awesome result for small cap value.

Both charts compare actual, investible funds and pit them against each other over the longest possible time period to avoid cherry-picking dates.

The reason we stress this point is that the case for small cap value and other market-beating “risk factors” is often made using theoretical stock indices and back-tested simulations.

But the real test of any strategy is what happens when it becomes available in investible form. Does it actually work in real-life conditions?

For small cap value, the answer is a resounding “yes”. The strategy can successfully beat markets across the world despite real world frictions.

Why are small cap value stocks capable of beating the market?

 There are two main theories in play.

The first is a straightforward risk-reward story.

Without a doubt, small cap value stocks are riskier on average than the overall market.

They’re highly volatile and typically fall further during stock market declines. Essentially, this type of company is more vulnerable when the economy misfires.

This inherent risk leads many investors to avoid small value firms. Hence, you can snap up the stocks at low prices, which means they can pay off handsomely if the risk side of the equation proves overblown.

The second explanation is more psychological.

The hypothesis is that people are highly attracted to companies with exciting growth stories. Those narratives can cause investors to overpay for firms that promise to change the world with their AI chatbot, or robots, or rocket ships, or NFTs and blockchain applications a few years ago.

If the hype outruns reality, then investors experience substandard returns when the stock price fails to grow as expected.

Conversely, — the behavioral theorists argue — many people shun boring, debt-laden firms mired in industries that reek of stagnation.

Many small cap value companies fit that profile.

Hence, you can buy up those stocks for a song and make a tidy profit when the reality proves less doomy than the story.

Either way, small value’s track record speaks for itself.

100 % small cap value?

 OK, then, so why aren’t we all 100 % invested in small value stocks?

The most important reason is that there’s no guarantee the strategy will continue to outperform in the future.

To understand why, imagine that everyone pulls their money from the tech giants and pours it into small value shares.

That wave of cash would drive the price of small value stocks through the roof.

They’d move from undervalued to overvalued, and their secret sauce would be gone.

In a nutshell, that’s the unavoidable risk you take with any strategy. If the price is pumped up too far, then your opportunity to make a large profit evaporates.

The other risk is that small cap value stocks languish unloved and out of favour for years on end.

This risk has materialised in the US in the last decade, where US small cap value has only beaten the S&P 500 two years out of the last ten.

The decade before that, US small cap value won seven years out of ten.

Does the recent underperformance of US small cap value mean the strategy no longer works?

Probably not. International ex US small cap value beat the international ex US market seven years out of the last ten. And 14 out of the last 20.

The small value premium still appears to be alive and well outside the US. Moreover, past returns show that years of underperformance are nothing unusual. The strategy is highly cyclical.

Throw in small value’s volatility, and the risk it fails to work in the future, and you have a clear explanation as to why no-one recommends going all-in.

Small cap value diversification against tech stocks

 There’s much talk about elevated US stock market valuations and the degree to which that’s driven by the tech giants.

Investor concern about over-concentration in US mega-caps has triggered the launch of five MSCI World ex USA ETFs in less than two years.

A small value ETF is another way to address that issue.

In this case, you’re not diversifying away from the US economy, but from the tech stocks that are driving the S&P 500, and to a lesser extent the MSCI World index.

Small cap value ETFs typically feature a tech sector allocation in the range of 6 to 10 %. That compares to over 30 % in the MSCI World and closer to 40 % in the S&P 500.

Indeed, this approach paid off the last time tech sector hype ended in a stock market crash: the infamous Dotcom Bust.

On that occasion, small cap value funds actually rose while the S&P 500 fell 42 %.

Finding small cap value ETFs

 There are three small cap value UCITS ETFs currently available: 

• Avantis Global Small Cap Value UCITS ETF USD Acc (AVSG)
• SPDR MSCI USA Small Cap Value Weighted UCITS ETF (ZPRV)
• SPDR MSCI Europe Small Cap Value Weighted UCITS ETF (ZPRX)
• Dimensional Global Targeted Value UCITS ETF

All four ETFs come from reputable providers.

As you can see, Avantis and Dimensional offer the convenience of global diversification in a single product. Those two providers are also value investing specialists.

Note that small cap and value strategies are not the same as small cap value.

The value strategy is dominated by large cap value stocks.

While small cap strategies focus on smaller sized companies, but not necessarily cheap ones.

The reason this matters is that small cap value has historically occupied a sweet spot: capturing more of the size and value premium than the two standalone strategies.

Over the longer run, you’d have been much better off investing in small value than either small cap or value.

Past is not prologue, of course. The historical record does not dictate the future. But if the risk-reward story is true, then the greater risks and rewards are to be found in the small value strategy.

Is small cap value essential?

 No. A straightforward, buy-and-hold strategy powered by global equities is still a great option.

But if you’re prepared to take more risk in search of additional reward, then small cap value has a lot going for it.

Summary of the pros and cons:

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