I designed the Vigorous Value Portfolio for those wanting to heavily tilt Size and Value. Below are the details on its components and fund selection.
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What is the Vigorous Value Portfolio?
Based on the current research on asset pricing, most seasoned investors think it’s sensible to overweight, or tilt, Emerging Markets stocks, Value stocks (stocks thought to be underpriced relative to their book value), and small stocks relative to their market weights. I designed this aggressive 100% stocks portfolio to do that globally to an extent greater than what is typically seen, while maintaining diversification across cap sizes and geographies. I dubbed it the Vigorous Value Portfolio because it does indeed tilt Value quite vigorously, and because we would expect it to be more volatile than something like 100% VT or the S&P 500.
This portfolio is not unlike Paul Merriman’s 4 Fund Portfolio, but this one more meticulously avoids small cap growth stocks and goes beyond U.S. borders. I’ll explain these details below.
The Vigorous Value Portfolio looks like this:
15% U.S. Large Cap Blend
15% U.S. Large Cap Value
30% U.S. Small Cap Value
10% Emerging Markets
10% Emerging Markets Small Cap Value
5% Developed Markets (ex-US)
5% Developed Markets (ex-US) Large Cap Value
10% Developed Markets (ex-US) Small Cap Value
This portfolio uses a 60/40 ratio of U.S. to international stocks, 2:1 Value to Growth, roughly 1:1 large caps to small caps, and 1:1 Developed Markets to Emerging Markets. Here’s that visualized in the Morningstar X-Ray:
Below I’ll explain the reasoning behind each asset and subsequent fund selection in detail. Fund selection was based primarily on factor loading and secondarily on liquidity and fees.
U.S. Large Cap Stocks – 15%
The U.S. stock market comprises roughly half of the global stock market. The Value and Size premia have experienced periods of underperformance historically, so part of keeping some large cap growth exposure comes from U.S. large caps, in this case the famous S&P 500 Index – considered a sufficient barometer for “the market” – via Vanguard’s VOO. This segment captures household names like Amazon, Apple, Google, Johnson & Johnson, Microsoft, etc.
Why not use VTI to capture the entire U.S. stock market including some small- and mid-caps? I’ll answer that later.
U.S. Large Cap Value – 15%
Though the Value premium has suffered over the past decade, there’s no legitimate reason to think that it has disappeared. That is, on average, we would still expect Value stocks to outperform Growth stocks over the long term. Interestingly, there have been more 10 year periods where the market delivered a negative premium than 10 year periods where Value delivered a negative premium.
I don’t employ or advise market timing, but AQR maintains that Value is basically the cheapest it’s ever been right now relative to history with the largest valuation spread between Value and Growth, suggesting that now may actually be the worst time to give up on the factor, and that it’s due for a comeback.
For this component I’m suggesting RPV, the Invesco S&P 500 Pure Value ETF. As the name suggests, this fund seeks to track the S&P 500 Pure Value Index. RPV is the best fund I’ve found for exposure to the Value factor in U.S. large caps; it has much greater exposure than competitors like VLUE, VTV, and IUSV. Conveniently, the fund also delivers positive loading to the Profitability factor.
U.S. Small Cap Value – 30%
I didn’t use VTI (total U.S. stock market) here because I want to avoid those pesky small-cap growth stocks which don’t tend to pay a risk premium. Even mid-cap growth hasn’t beaten large cap blend historically on a risk-adjusted basis. We do get some mid cap exposure from the international indexes, but this portfolio takes a barbell approach for the U.S. stocks, only getting growth exposure in large caps.
Specifically, small cap growth stocks are the worst-performing segment of the market and are considered a “black hole” in investing. The Size factor premium – small stocks beat large stocks – seems to only apply in small cap value. As Cliff Asness from AQR says, “Size matters, if you control your junk.” Basically, if you want to bet on small caps, the evidence suggests to do so in small cap value, preferably while also screening for profitability.
By “risk premium,” I’m referring to the independent sources of risk identified by Fama and French (and others) that we colloquially call “factors.” Examples include Beta, Size, Value, Profitability, Investment, and Momentum. I delved into those details in a separate post that I won’t repeat here, but I’ll be referring to these factors and their benefits quite a few times below. Though it may sound like magic, the evidence suggests that overweighting these independent risk factors both increases expected returns over the long term and decreases portfolio risk by diversifying the specific sources of that risk, as the factors are lowly correlated to each other and thus show up at different times.
The fund I’ve chosen for U.S. small value tracks an index that also screens for strong financials, conveniently providing some exposure to the Profitability factor as well. That fund is VIOV from Vanguard. Full disclosure, I recently replaced it with the new fund AVUV from Avantis in my own portfolio (I explained why here), but AVUV is actively managed, so I can’t make a blanket recommendation to others for that fund given that VIOV is a fine choice to capture this market segment; I wouldn’t include it if it weren’t.
Some will note that Vanguard’s VBR is cheaper and more popular. I discussed here why VIOV is demonstrably better. In short, VIOV has superior factor exposure across the board, as VBR calls itself a small value fund but is unfortunately not very small or very value-y.
Small cap stocks only make up about 6% of the market at their market weight, of which small cap value is about half that. Here we’re giving small caps room to shine by weighting them equal to large caps.
Emerging Markets – 10%
Emerging Markets refer to developing countries – China, Hong Kong, Taiwan, India, Brazil, Thailand, etc.
Stocks in these countries have paid a significant risk premium historically, compensating investors for taking on their greater risk. Arguably more importantly, Emerging Markets offer a lower correlation to U.S. stocks compared to Developed Markets, and thus are a superior diversifier.
At its global weight, the U.S. only comprises about half of the global stock market. Most U.S. investors severely overweight U.S. stocks (called home country bias) and have an irrational fear of international stocks.
No single country consistently outperforms all the others in the world. If one did, that outperformance would also lead to relative overvaluation and a subsequent reversal. Consequently, we want to diversify across geographies in stocks.
During the period 1970 to 2008, an equity portfolio of 80% U.S. stocks and 20% international stocks had higher general and risk-adjusted returns than a 100% U.S. stock portfolio. Specifically, international stocks outperformed the U.S. in the years 1986-1988, 1993, 1999, 2002-2007, 2012, and 2017.
In short, geographic diversification in equities has huge potential upside and little downside for investors.
Emerging Markets only comprise about 11% of the global stock market. This is why I don’t use the popular VXUS (Vanguard’s total international stock market fund) – because its ratio of Developed Markets to Emerging Markets is about 3:1. Here we’re using a 1:1 ratio of Developed to Emerging Markets. I delved into this in a little more detail here.
Vanguard’s Emerging Markets ETF is VWO.
Emerging Markets Small Cap Value – 10%
Just like in the U.S., we also want to specifically overweight small cap value stocks in Emerging Markets, as the Size and Value premia show up at different times across geographies.
There’s currently no ideal fund for this very narrow segment of the global market. I’m hoping Dimensional or Avantis launches one at some point, but for now we’re using a small cap dividend fund from WisdomTree as a proxy for Value within small caps. Don’t let this sound discouraging. The fund also screens for strong financials and has appreciable loading across Size, Value, and Profitability. The fund is DGS, the WisdomTree Emerging Markets SmallCap Dividend Fund.
Developed Markets – 5%
Developed Markets refer to developed countries outside the U.S. – Australia, Canada, Germany, the UK, France, Japan, etc.
While Emerging Markets are the better diversifier for U.S. stocks, there’s no reason to completely avoid Developed Markets, as there have been years where they outperformed the rest of the world (including the U.S.).
Vanguard offers a low-cost fund called the Vanguard FTSE Developed Markets ETF. Its ticker is VEA.
Developed Markets Large Cap Value – 5%
As we did in the U.S., we can overweight large cap value in Developed Markets with EFV, the iShares MSCI EAFE Value ETF.
Developed Markets Small Cap Value – 10%
Lastly, we also want to overweight small cap value stocks in Developed Markets.
Avantis recently launched a fund available to retail investors that specifically targets international small cap value in Developed Markets – AVDV.
I know I’m being a bit hypocritical in suggesting the actively-managed AVDV here while refusing to include the actively-managed AVUV for U.S. small value above. I think this case is different because there are far fewer options for ex-US small value. Prior to the launch of AVDV, we were forced to use another dividend fund from WisdomTree (DLS) as a proxy for small cap value in Developed Markets.
AVDV is currently the only fund available to the public that specifically targets Size and Value (and conveniently, Profitability) in ex-US stocks. As a bonus, AVDV is also roughly half the cost of the former option DLS.
Vigorous Value Portfolio – Historical Performance
Some of these funds are pretty new, so I had to use comparable mutual funds in some cases to extend this backtest. The furthest I could get was 2000, going through February 2021:
Here are the annual returns:
Here are the rolling returns:
Keep in mind the Size and Value premia and international stocks have suffered over the past decade, otherwise I think the differences in performance metrics would have been even greater.
Vigorous Value Portfolio Pie for M1 Finance
So putting all the funds together, the resulting Vigorous Value Portfolio looks like this:
- VOO – 15%
- RPV – 15%
- VIOV – 30%
- VWO – 10%
- DGS – 10%
- VEA – 5%
- EFV – 5%
- AVDV – 10%
You can add this pie to your portfolio on M1 Finance by clicking this link and then clicking “Save to my account.”
Questions, comments, concerns, criticisms? Let me know in the comments.
Disclosure: I am long VOO, AVUV, VEA, VWO, and AVDV in my own portfolio.
Disclaimer: While I love diving into investing-related data and playing around with backtests, I am in no way a certified expert. I have no formal financial education. I am not a financial advisor, portfolio manager, or accountant. This is not financial advice, investing advice, or tax advice. The information on this website is for informational and recreational purposes only. Investment products discussed (ETFs, mutual funds, etc.) are for illustrative purposes only. It is not a recommendation to buy, sell, or otherwise transact in any of the products mentioned. Do your own due diligence. Past performance does not guarantee future returns. Read my lengthier disclaimer here.