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Over the years, I have seen several investment experts suggest they are ‘tilting’ their portfolio one way or another. It sounds sophisticated. They might generally follow total stock market indexing principles, but they deviate ever so slightly into a certain strategy. They tilt their way into ‘international equities,’ ‘value stocks,’ or even ‘alternatives.’
Tilt: move or cause to move into a sloping position.
As they tout their tilt, I sometimes have a hard time reading between the lines to understand the why. Do they know something I don’t? Do they understand this risk and reward relationship?
The thing is, many of these investment experts aren’t experts at all. Just like Max, they are completely random characters from in and around the internet. So be careful following advice from the internet masses without fully understanding the risk. That includes me.
I suppose everyone is happy this isn’t another baby post; let’s stick with personal finance today.
Total Stock Market Index
I remember stumbling across Vanguard when my wife worked for a small school down in North Carolina that did their 403(b) through them. I immediately noticed how low their fees were compared to some of my previous workplace accounts. My understanding is its founder is the one who made index fund investing available to the average Joe Max. He passed away just over two years ago.
Don’t look for the needle in the haystack. Just buy the haystack!”Jack Bogle, Vanguard founder
Historically, I have always been mostly invested in market-cap-weighted total stock market index funds such as the now-famous VTSAX. The goal was simple. I piled as much money as possible into the total market and did not worry about squeezing an extra 0.5% return while the balance was immaterial. Salary, career progression, and expense management were much more valuable and could move the needle quicker than investment returns.
That led me to buy a piece of all 3,600 or so companies available on the public stock exchange and leave it at that. When the total stock market wasn’t available, I would settle for the 500 companies that are part of the S&P 500. Either way, we are talking about purchasing large sections of the US economy here. Haystacks.
But as balances grow, so does strategy.
As I developed my investor policy statement in late 2020 I worked on rationalizing my risk tolerance. In particular, I looked closely at my US equity allocation. I decided it was finally time to tilt my way into small caps. I am using a lesser-known Vanguard fund called VSMAX to make that happen.
Initially, I considered buying haystack healthcare-focused companies. Ultimately, I decided against it due to lack of diversification from my livelihood, healthcare finance.
My motivation for this small-cap tilt is risk management and hopefully some reward in the long term. It will be a slow process, probably years in the making.
According to Investopedia, a small-cap company is a company that has a small market capitalization. Their definition suggests a market capitalization range of between 300 million to 2 billion dollars.
My writing surrounding my ‘pet’ medical office building portfolio was primarily focused on Physicians Realty Trust (DOC). Physicians Realty Trust has a market capitalization of $3.54 billion at the time of writing this. That puts them out of range for this narrow definition.
We get the market capitalization by taking the number of shares and multiplying it by DOC’s current stock price.
208,230,000 Shares X $17.00 Per Share = $3.54 billion
You can also just look it up if you have a hard time with multiplication.
I currently own about 1,200 of those 200 million shares in my taxable brokerage account. As an owner, the company pays me about $1,000 every year in passive income. That covers over 2% of our annual living expenses.
$3.4 billion is a drop in the bucket compared to Tesla’s market capitalization of about $648 billion. That’s more than half a trillion dollars. Coca-Cola comes in at about $210 billion at the time of writing this. Etsy has a market capitalization of about $27 billion.
So, none of these companies meet the Investopedia definition of a small-cap company. So they must be too big to fit into my small-cap VSMAX haystack, right? Wrong.
Interestingly enough, I found a few of them in my index fund.
Buying an Entire Haystack of Small-Cap Stocks
As I mentioned, I generally consider myself an index fund investor. I occasionally play around with individual stock for excitement and education, but that generally represents less than 10% of our portfolio. I know better than to scour the entire stock market for that one needle that will outperform everyone else.
So, when I look to tilt my portfolio in a certain direction, I tend to use giant haystacks. Not individual stocks.
In this case, the haystack is VSMAX, and it currently holds about 1,420 companies. Like most things at Vanguard, it is really cheap to own, with an expense ratio of only 0.05%.
Yes, it has my name, Max, in it. No strategy there, purely coincidental.
As I poked around this fund, I was surprised to find it holds both Physicians Realty Trust (DOC) and Etsy. That’s because Vanguard has its own definition of small-cap companies. The definition is a bit technical and not something I am looking to cover today. But it certainly threw me off at first.
So when I buy this index, I am essentially buying these companies along with 1,418 other companies.
Small Caps and Risk
Small-cap companies are generally more volatile and come with more risk than their obese friends. In some cases, newer companies do not have a solid foothold in their industry yet and struggle to compete. But sometimes, their growth can be explosive. We all know Coca-Cola will hold its value and probably outlive me by hundreds of years, but it’s much harder for it to grow because it is already so big. That’s where small-cap stocks come in.
VSMAX gives me a blend of value and growth, which is likely why they let some of those larger stocks in there like DOC.
Vanguard does a great job calling out the risk the comes along with owning small-cap stocks. They created a bar graph to help people visualize the risk a little better. VSMAX hits the highest number on the risk-o-meter.
We can compare this with the total stock market index fund, which only hits a 4 on the same meter.
Why is Max Taking on More Risk?
A few things to call out here. I have read a few pieces about how much of the total stock market is made up of Facebook, Amazon, Apple, Netflix, Alphabet (Google). They call them the FAANG stocks, and we are talking mega-cap companies. Amazon comes in at $1.6 trillion, close to the almost approved $1.9 trillion dollar stimulus package.
In theory, because the entire market (VTSAX) is market-cap weighted, it might make our portfolio a bit overweight with these companies when we own it.
I will add a few to the list.
These ten companies (out of 3,600) make up 23.60% of the total stock market index as of January. I have enjoyed long-term success as the total stock market index reaped the rewards from the value created by these world-class companies over the last decade or more. But in my eyes, our portfolio has become a bit overweight with assets from these ten companies alone. So, I am looking to tilt my diversification (ever so slightly) away from them.
Flash Back to 1992
In 1992, the top ten holdings in this fund looked very different and only encompassed about 14% of the fund. It included companies like Exxon Mobil, Walmart, and General Electric.
FAANG stocks will likely dominate the industry for years to come, but I also know a whole generation is coming up that refers to Facebook as “mom book.” How will that pan out for Facebook 30 years from now? Even I stopped buying Apple products years ago, and Paramount got my attention with their Superbowl ads. We might ditch Netflix to get more access to sports (they are no longer in the top 10).
It’s not just Max, regulators are also looking at their size.
There is much more to discuss here, and some of it is out of my league. So I will leave it at that. I probably do not understand the technicals and self-cleansing nature of the market, but the overarching argument makes common sense to me. Common sense isn’t that common anymore.
The top ten companies in my small-cap haystack look quite different and only represent 3.6% of the entire index. This is the type of diversification I am currently on the hunt for.
I just looked up Plug Power – they are building the clean hydrogen economy. Glad I could do my part investing in clean energy.
Max doesn’t have a crystal ball here. Odds are I will lose. I have to go back 20 years to find a period of time where this small-cap index actually beat the total stock market index on an average annual performance basis. The margin is about 1.86%.
But I also know 1.86% on a million dollars is $18,600 in one year. Multiply that over 20 years, and it is something worth looking into. I have also read that small-cap stocks might be better positioned to come out of the pandemic stronger since they are lean. Most importantly, I don’t think this is breaking the first philosophy bullet of our investor policy statement.
Automation, Simplicity, Systemness (*I like this word)
Our portfolio will always own a big piece of VTSAX, but tilting doesn’t hurt. I have thought about playing around with “equal-weighted funds” in place of market-cap-weighted funds. But for now, I am happy to (very) slowly tilt our portfolio into a small-cap arena to offset some of the imbalance I perceive in the total stock market index. My $100,000 opportunity fund has given me some confidence to take on this additional risk.
Since early January, I have moved close to $25,000 in that direction. I will eventually set an allocation for rebalancing purposes and forget it.
Do you think small-caps are worth looking into? Are there books worth pointing me to? Thoughts on pushing from blend to growth?