Factor Investing: Why We Tilt Toward Small and Value Stocks

Key takeaways

The size, value, and profitability premiums appear across nearly a century of U.S. data and in international markets, which makes them unlikely to be accidents.
The premiums are compensation for risk and for behavior, and they show up irregularly, with decade-long stretches of underperformance.
A modest tilt, implemented through low-cost systematic funds, captures much of the expected benefit without betting the portfolio on it.
The tilt only works for investors who will hold it through the years it looks wrong.

An index fund buys the whole market in proportion to company size. That makes it the cheapest, most diversified way to own stocks. It also means the portfolio is dominated by the largest, most expensive, most popular companies at any given moment. Factor investing starts from the evidence that certain other groups of stocks have done better over long periods and asks whether a portfolio should lean toward them. Ours does, modestly. This is why.

The premiums

In 1992, Eugene Fama and Kenneth French showed that two characteristics explained much of the variation in stock returns beyond overall market exposure: company size and price relative to book value. Smaller companies had outperformed larger ones, and cheaper companies (value) had outperformed more expensive ones (growth), by meaningful margins over the nearly three decades of data they studied. Later research by Robert Novy-Marx and others added profitability: among companies with similar prices, the more profitable ones did better.

These findings have held up in ways most academic results don't. They show up in U.S. data going back to the 1920s, in the decades after the papers were published (an out-of-sample test the researchers themselves pushed for), and across developed and emerging markets. Size has been the weakest and most debated of the three. Value and profitability are among the most robust results in finance.

Why they exist

Two explanations have support, and both suggest the premiums will stick around.

The risk story: small and value companies are riskier in ways that matter to investors. They're more exposed to recessions, have less financial flexibility, and suffer more when things go bad. Investors demand higher expected returns to hold them, and higher expected returns is exactly what the data shows.

The behavioral story: investors overpay for exciting growth stories and underpay for boring, troubled, or small companies. The mispricing corrects slowly, because arbitraging it away is costly and takes more patience than most professionals can afford.

If the premiums are compensation for risk, they won't disappear, because risk doesn't. If they're behavioral, they won't disappear either, because the behavior is durable. Either way, this isn't free money. It's payment for something.

The cost: long stretches of looking wrong

From roughly 2007 to 2020, U.S. value stocks underperformed growth stocks by one of the widest margins on record, as a handful of large technology companies carried the market. An investor tilted toward value trailed the S&P 500 for over a decade. Then, in 2021 and 2022, value snapped back. That pattern, years of underperformance followed by a recovery that shows up without warning, is just what the premium looks like. The 1990s went the same way, ending in 2000 with a value rally that ran seven years.

Which is why the tilt has to be sized to the person holding it. A portfolio that's 100% small value will, at some point, trail the market by a wide margin for a long time, and most people can't sit through that. A modest tilt trails by less, still captures a meaningful share of the expected premium, and can actually be held.

How we implement it

Systematic, not active. We use funds from managers like Dimensional and Avantis that are built on this research. They hold thousands of stocks, weight them toward size, value, and profitability by rule rather than manager judgment, trade patiently to keep costs down, and charge expense ratios that are a fraction of what active managers charge. The evidence supports capturing factor exposure this way, not by picking stocks.

Modest. A typical tilt in our portfolios starts from broad market index funds and adds dedicated small-company and value funds alongside them, so the portfolio leans toward the premiums without leaving the market behind. We're after an expected return somewhat above the market, with tracking error clients can live with.

Global. The premiums show up internationally, and tilting across countries diversifies the timing of when each one pays.

Located well. Factor funds tend to have somewhat higher turnover and dividend yields than a broad index fund, so they're good candidates for the Roth and IRA under our asset location rules, with the broadest funds in taxable accounts.

Rebalanced. When the tilt has trailed, rebalancing buys more of it at lower prices, which is when the expected premium is highest. When it has led, rebalancing trims it. That discipline is what turns a long-run average into a return you actually get.

What we tell clients

The tilt is expected to help over decades. It's expected to hurt over some years. And we can't tell you which years in advance. We size it so the bad years are tolerable, and we don't change it because of recent performance in either direction, because chasing whichever factor just did well is precisely the behavior the premiums feed on. That conversation happens before anyone invests. The tilt is part of investment management here because the evidence supports it, not because it's fashionable.

Frequently asked questions

Are factors the same as smart beta?

Smart beta is a marketing term for index funds that weight by something other than market capitalization, which covers factor strategies and a lot of other things. Not every smart beta fund is built on a well-documented premium or run at low cost. The label isn't the evidence.

Should I tilt in a taxable account?

Factor funds are reasonably tax-efficient, but less so than a broad index fund. Where there's room, we put them in tax-advantaged accounts and hold the broadest funds in taxable.

Is now a good time to tilt toward value?

We don't time factors. Value has been relatively cheap versus growth for much of the last decade, and some research ties that to higher expected premiums, but nobody knows when the recovery arrives. The tilt is a permanent feature, not a trade.

What about momentum and other factors?

Momentum is well documented but expensive to capture because of the turnover. Quality, low volatility, and the rest have evidence of varying strength. We stick with the three that have the longest records and the clearest explanations, and we let the systematic funds handle the implementation details.

Joseph G. Valerio, CFP®, EAFounder and Lead Advisor at Valerio Wealth Management, a fee-only, fiduciary virtual family office in Miami, Florida. One advisor, credentialed in both financial planning and federal tax. About Joseph

This article is general education, not individualized advice, and it is not tax, legal, or accounting advice. Figures reflect federal law for the year stated and can change. Valerio Wealth Management does not prepare or file tax returns. Speak with a qualified professional about your own situation before acting.