In a recent Wise Investing column at CBS MoneyWatch.com, "A Simple Way to Beat the Market," Larry Swedroe argues that one simple way to beat the market is to invest in passively managed funds that buy small-cap and value stocks. To back up his argument, Swedroe cites the relative out-performance of small-cap, small-cap value, and large-cap value stocks from 1927 to 2009.
Aside from the fact that past performance is, as they say, no guarantee of future performance, one reason why investors may want to think twice before adopting such a strategy is because that market-beating performance over eight decades has masked dramatic swings in the interim that might have afforded investors good opportunities to enhance returns or reduce risk.
While I don't have access to the Fama/French database used by Mr. Swedroe, a quick read of how the large-cap laden S&P 100 index has performed relative to the Russell 2000 small-cap index over the course of many years gives us some perspective on the potential downsides of such an approach.
All Indices Have Their Moments
First off, it's true that the S&P 100 has lagged the Russell 2000 by 55% since small-cap stocks began a cyclical upswing just over 10 years ago. But in the years before that, the shares of the largest companies were undoubtedly the place to be. In fact, from May 1986 to December 1999, the former outpaced the latter by an eye-popping 127%.
Even the more recent, though less-pronounced, cyclical moves in favor of large-cap shares have been nothing to sneeze at. From April 2006 to January 2008, for example, the S&P 100 beat its small-cap counterpart by 21%. In the fall of that same year -- around the time of the Lehman Brothers bankruptcy-inspired financial crisis -- small-cap stocks lost 25% on a relative basis in just two months.
Of course, highlighting those periods when large-cap stocks have fared best is easy in hindsight. But in looking back over the span for a telltale sign of when large-cap shares might outperform their small-cap brethren, one thing stands out.
As the accompanying chart suggests, when the ratio of the S&P 100 to the Russell 2000 approaches or falls below 0.8, it has generally signaled that a reversal of fortunes is not that far away. So, where is it now? Based on the latest closing values for those two indexes, the measure stands at 0.74.
To be sure, this indicator has not proved its mettle on a short-term basis, and has occasionally generated a signal many months before large-cap stocks have begun to outperform. Moreover, Mr. Swedroe himself acknowledges that those who adopt his approach will almost certainly have to weather periods when small-cap performance falls short of its longer-term pattern.
Still, the notion that there is a strategy for beating the market that fails to take account of potential double- and triple-digit percentage-point swings seems -- dare I say it? -- a bit short-sighted.