The smb investing strategy has become an increasingly popular approach for investors seeking to generate superior returns. This strategy focuses on investing in small cap value stocks, which have historically outperformed the broader market. At its core, the smb strategy aims to capitalize on the size and value effects – two well-known market anomalies. By tilting a portfolio towards smaller, value-oriented companies, investors can tap into the excess returns these stocks have tended to deliver over time. However, successfully implementing an smb strategy requires thoughtful design and discipline. Care must be taken to avoid potential risks such as increased volatility and liquidity challenges. Overall, when applied judiciously, an smb investing strategy centered around small cap value stocks can be an excellent way for investors to enhance portfolio returns.
The smb factor captures excess returns from small cap value stocks
The smb factor, short for ‘small minus big’, represents the historical return difference between portfolios of small cap and big cap stocks. This factor was first identified in the influential Fama-French three factor model, which found that smb and two other factors – market and value – explain over 90% of the differences in stock returns. Eugene Fama and Kenneth French demonstrated that small cap value stocks, as measured by the smb factor, have delivered significantly higher returns than large cap growth stocks over the long run. The premium associated with the smb factor has persisted despite scrutiny from academics and exploitation by investors. Consequently, tilting exposure towards companies exhibiting ‘smb characteristics’ has become a widely adopted strategy amongst institutional investors and savvy individuals alike.
Combining size and value effects creates a powerful return driver
The excess returns associated with smb investing stem from two underlying market anomalies – the size and value effects. The size effect refers to the historical tendency for small cap stocks to outperform large caps, while the value effect captures the phenomenon of value stocks beating growth stocks. Individually, size and value investing offer potential return benefits. However, research shows that combining the two generates even larger excess returns. This is because the highest returns have come from small cap value stocks, whereas large cap growth stocks have lagged. The smb factor offers efficient exposure to these sweet spot small cap value stocks. Rather than holding a basket of small value stocks directly, investors can gain smb exposure by holding a single asset – such as the iShares MSCI USA Small Cap Value ETF.
Controlling risks is critical for smb strategy success
While alluring, smb investing does entail risks that must be prudently managed. The inherent volatility of small cap stocks means an smb strategy will likely experience larger drawdowns compared to a broad market portfolio. Liquidity can also become an issue, as thinly traded small value stocks can be difficult to buy and sell efficiently. Turnover and trading costs are other concerns. To mitigate these risks, smb exposure should be sized appropriately within the context of a diversified portfolio. Blending smb with other factors can also help smooth out volatility. Additionally, smb strategies based on liquid ETFs rather than individual stocks can alleviate liquidity challenges. Controlled, rules-based rebalancing and prudent diversification are other solutions.
Research thoroughly when employing an smb strategy
The empirical evidence supporting smb investing is strong, but historical returns don’t guarantee future outperformance. Before committing to an smb strategy, investors should thoroughly research how small cap value stocks fit into their broader investment philosophy and portfolio structure. Factor diversification, implementation methods, performance expectations and risk tolerance should all be carefully considered. It is also prudent to assess if prevailing economic and market conditions could impact the viability of an smb strategy going forward. While rewarding over the long-term, there have been multi-year periods where smb has underperformed. Being aware of this cyclicality can help manage expectations.
When thoughtfully deployed, an smb investing strategy focused on small cap value stocks can provide investors with an attractive avenue for enhancing portfolio returns over time. However, managing risks associated with size, value and liquidity factors remains imperative.