This type of rationale can also be applied to the equity markets with the size and value factors. Fama and French wrote about this nearly 30 years ago, with the implications being implemented by Dimensional Fund Advisors (DFA) and others in the financial industry.
Many investors don't maximize the diversification benefits that are available in the equity components of their portfolios. Diversification is often thought of primarily as a stock/bond allocation decision, but there is more to it. Market cap weighting means that even a total stock market fund is still nearly identical to the S&P 500. Whether it's large or small stocks, growth or value, domestic or International...bear market correlations do generally (but not always) rise in equities (meaning they all tend to decline at the same time). But there is more to diversification than just the temporary declines associated with bear markets. Let's look at a simple example:
S&P 500 annualized return: 18.21%
DFA Equity Balanced Strategy Index: 13.71%
S&P 500 annualized return: -0.96%
DFA Equity Balanced Strategy Index: 7.40%
S&P 500 annualized return: 12.75%
DFA Equity Balanced Strategy Index: 10.44%
S&P 500 annualized return: 9.93%
DFA Equity Balanced Strategy Index: 10.88%
The S&P 500 may indeed be a passive index, but only (or heavily) allocating to it for a portfolio is indeed an active decision since it only represents US large cap stocks. It almost certainly should be a part of a well diversified equity portfolio, but so should small cap and International equities. Tilts towards small and value may also offer investors a return premium, or at minimum, diversification benefits. The starting point for an equity investor should be a globally diversified portfolio as a sensible way to earn the equity risk premium.
Jesse Blom is a licensed investment advisor and Vice President of Lorintine Capital, LP. He provides investment advice to clients all over the United States and around the world. Jesse has been in financial services since 2008 and is a CERTIFIED FINANCIAL PLANNER™. Working with a CFP® professional represents the highest standard of financial planning advice. Jesse has a Bachelor of Science in Finance from Oral Roberts University. Jesse is managing the LC Diversified portfolio and forum, the LC Diversified Fund, as well as contributes to the Steady Condors newsletter.