Are You Being Fully Compensated for Risks Taken by Under-Exposure to Small Cap and Value Stocks?

There can be a potential performance advantage to tilting a core equity portfolio to smaller cap and value stocks, as was demonstrated by the work of Eugene F. Fama and Kenneth R. French in the early 1990s.

A market-weighted index is a common means of capturing total equity market exposure. Many investors believe that owning companies in proportion to their size in the market – as determined by the number of shares available to the public and the market price of the stock – creates the “optimal stock portfolio.”

But academic research and empirical evidence suggest that market weighting builds in a bias toward speculative growth and larger companies. Growth companies typically trade at higher multiples to their earnings or book value. The price for the firm’s stock is higher and so, in turn, is its market capitalization.

The investor who seeks total equity market exposure via a market-weighted index may pay more for each dollar of earnings or equity for growth companies. At the same time, he or she may not be fully compensated for the risks being taken by under-exposure to small cap and value stocks.

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