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Mindy Jensen: In the past year, we’ve been talking a lot about portfolio theory on the podcast, which means you’ve heard guests like Frank Vasquez share this advice: add small-cap value to your portfolio. But what does that actually mean? What is small-cap value investing? And does it really outperform the market over the long term? And more importantly, is AVUV actually the best way to invest in it? If you’ve ever felt confused about small-cap value funds, factor investing, or whether this strategy belongs in your portfolio, this episode will break it all down. Hello, hello, hello, and welcome to the BiggerPockets Money Podcast. My name is Mindy Jensen, and with me as always is my Where’s-All-the-Caps co-host, Scott Trench.
Scott Trench: Thanks, Mindy. I’ll factor that intro in and think about wearing a cap next time. All right, today we’re joined by Ben Felix. Ben is a portfolio manager and the chief investment officer at PWL Capital. He’s going to help explain what small-cap value investing actually is, why it matters for building towards financial independence, and whether funds like AVUV live up to the hype. As a reminder, this episode, as always, is not investment advice and is for entertainment purposes only. Ben, welcome to BiggerPockets Money.
Ben Felix: Thank you so much for having me. You guys bring energy. Holy smokes. My podcast is like nap time compared to this.
Scott Trench: I think you’re going to bring a lot of information and energy, but I’m not worried. I think you are just a master at these subjects. I follow your YouTube channel. It’s fantastic. And I think folks listening to the BiggerPockets Money Podcast should definitely go ahead and subscribe there because you provide really great information. What is it, like once a week or so?
Ben Felix: The podcast is once a week. My YouTube channel is once every 2 weeks.
Scott Trench: Go check that out. Yeah, could you tell us a little bit about yourself and your background?
Ben Felix: Sure, yeah. I am, as you said, the Chief Investment Officer at PWL Capital, which is a Canadian wealth management firm. I’ve been with PWL for, geez, I think 13 years, or I can’t remember. It’s somewhere between 12 and 14. I don’t know, it’s been a while. We use, roughly speaking, the type of investment strategies that we’re going to talk about in this episode, and we’ve been doing that for many, many years. It’s kind of one of the founding principles of our firm and one of our big beliefs. I, as you said, have a YouTube channel where I talk about, I don’t know, investing topics, but I just recorded a video earlier today about the elements of living a good life. So I try to cover broad topics, but with a very evidence-based lens. Then I’ve also got a podcast that I do, as I said, once a week where we interview— we alternate between interviewing literally the smartest people in the world when it comes to financial topics, including a lot of the people who came up with the theory that is behind the products that we’re going to talk about in this episode, and then doing episodes where we do deep dives on topics.
Scott Trench: Let’s frame the discussion here and talk about factor investing in a general sense. We’re here to talk about specifically some of the value investing funds provided by Avantis and what their edge is in your opinion, but could you give us a quick overview about why we’re interested in factor investing in the first place?
Ben Felix: Oh man, that’s a big topic. It’s basically like index funds. Your audience, I’m assuming, is familiar with index funds.
Scott Trench: Of course, yes.
Ben Felix: It’s like just all the stocks in the market at the weights in which they exist in the market. That’s a total market index fund. Those make sense in theory because markets are efficient, and if markets are efficient, it should be really hard to beat the market, which in reality it has in fact been. Now, the general premise of index funds is based on what’s called a single-factor asset pricing model. This is going to get nerdy fast. I hope that’s okay. The capital asset pricing model is the original asset pricing model that attributed returns, differences in returns between diversified portfolios, to exposure to market risk, which is what you get just from owning the market. That was a big deal when we had the CAPM in the 1960s. It really changed how we thought about financial markets. It changed how we thought about evaluating active managers, because prior to the CAPM, we had really no way to measure did an active manager do a good job relative to the amount of risk that they took. And so we get this new tool, and all of a sudden things start making more sense, and academia really took off from there. This is a literature called asset pricing. But there was a problem, or a few problems, with the CAPM where certain types of stocks were performing differently than the capital asset pricing model predicted. So it looked like— the measure is called alpha— it looked like some types of stocks had higher returns than could be explained by their exposure to market risk. And so everyone’s kind of freaking out, not actually, but they’re writing papers trying to figure out, like, what’s going on here? Is the market inefficient, or is our asset pricing model wrong? And so 2 academics, Eugene Fama and Ken French, who people make fun of me for mentioning in almost every video, which is probably true, they came up with this idea that, well, maybe we have these— what were called anomalies. We have these types of stocks that just aren’t making sense with the asset pricing model that we have. Maybe it’s not a problem with market efficiency. Maybe it’s a problem with the asset pricing model. They came up with this idea: what if we included factors— they’re called asset pricing factors— related to small companies and lower-priced companies, which we know commonly as value stocks? They said, okay, if we make this 3-factor asset pricing model, maybe we can explain a lot of these anomalies that we’re seeing. They did that. They tested it. It did indeed explain a lot of the anomalies. That paper in 1993 really created this— what has now become a massive field of study called multifactor asset pricing. It’s basically trying to find systematic attributes that explain differences in returns across stocks, which is interesting in an academic sense, because again, we can benchmark active managers. Did they outperform, or did they just take a small-cap value tilt? It’s also interesting because if we know that there are factors that exist, and we believe that their premiums— I should explain what that means. We expect a market premium for owning stocks over bonds because stocks are riskier than bonds. We expect a small-cap premium based on Fama and French’s paper, although that one’s a bit dicey on its own. I can talk about that later. We expect a small-cap premium where small stocks outperform large stocks because small stocks are theoretically a bit riskier. And then likewise for value stocks, lower-priced stocks, we expect them to outperform higher-priced stocks. So value, we expect to outperform growth. It’s called the value premium, again, because value stocks are riskier. So we have all of these return premiums where an investor can say, you know, the market premium’s great and you can get that using low-cost index funds, but maybe I want to tilt toward other return premiums, other sources of expected return, like small cap and value.
Mindy Jensen: Yeah, you have thrown a lot of phrases at us that maybe our audience isn’t quite as familiar with as you are, which doesn’t make it bad. I just want to clarify some of these. So what is small cap? What does small cap mean?
Ben Felix: Yes, that is a fantastic question. So let’s start with market cap. What does market cap mean? Market capitalization is the full word. That’s a measure of the value of a company, and it’s calculated by multiplying its total shares by its price. So it’s really just, what is this company worth? So Nvidia, which is right now the biggest company in the US market, it’s got a market cap, which it’s crazy to even say, of $5.1 trillion. It’s like, what? Come on. And then Getty Images, which is the smallest holding in the Vanguard Small Cap Value ETF, has a market cap of $359 million. So those are the sizes of the companies measured by their value, which is measured by their shares multiplied by their share price. Now, small cap is actually really interesting. What is a small company? It depends who you ask. So I’ll talk a little bit more in general terms, but each index provider— so we have all these companies that create indices. S&P has their indices, CRSP has indices, MSCI has indices. Each one has its own way of defining what a small cap is. So I can’t say this is a small cap, like this size company, because it depends which index provider we’re talking about. But the general idea is that they’re sorting all the stocks in the market into size-based buckets. So the main buckets— and there are a couple other buckets— but the main buckets are large caps, which is just the largest stocks, mid-caps, which are in the middle, and small caps, which are the smallest stocks in the market. So when we say small caps, the specific definition varies, the precise number varies, but it’s roughly speaking the smallest stocks in the market. And if we think about average market caps, if we look at, like, the Vanguard Large Cap ETF— so that’s an ETF of the largest stocks in the US market— the average market cap is $350 billion. And if we look at the Vanguard Small Cap ETF, the average market cap is $10 billion. So you can see just kind of how the average market cap varies between large and small caps.
Mindy Jensen: You’re saying billion with a B, like that’s small or tiny, and that’s still a lot. But why would I want to invest in a small company that’s only worth billions when I could be investing in these larger companies that are measured in billions and now trillions with Nvidia?
Ben Felix: Small companies on its own, when we haven’t introduced value yet, which we can talk more about— but small companies on their own is actually a little bit tricky. I’m going to get nerdy again, I’m sorry. There was a paper in, I think it was 1981, where a guy named Rolf Banz comes out with this paper and shows, hey, small-cap stocks have outperformed, and they’ve outperformed by more than the capital asset pricing model would predict. They’ve beaten the market basically even when you adjust for risk. And that was interesting. That study— when you use current data, datasets have gotten better. There was a lot of survivorship bias in small-cap datasets. So when you rerun that study today, the outperformance of small-cap stocks is actually not as interesting on its own. But when you combine size with other factors like value, which we can talk more about, it does start to get more interesting. But to answer your question, Mindy, the main premise of this approach to investing is that these types of stocks— so small-cap maybe, but small-cap value probably more likely— have higher expected returns than larger stocks.
Mindy Jensen: Okay, first of all, the nerd energy is strong here, so don’t apologize.
Ben Felix: Okay, okay, good.
Mindy Jensen: Just get as nerdy as you want to. So you said small-cap and small-cap value are different. What does value mean?
Ben Felix: What does that factor mean when we’re talking about small-cap? The factors specifically, like in the Fama and French paper, they are measuring value using book-to-market, book price relative to market price, where a high book price relative to the market price is a value stock. If you look across index providers, value is another— practically speaking, value is another metric that has a whole bunch of different definitions. Again, MSCI and S&P and CRSP, they’re all going to be different, but the general idea is that we’re measuring the price of a company relative to some fundamental metric. So it could be its book value, it could be its earnings, it could be a host of other fundamental metrics. And it’s often actually a blend of a bunch of different metrics. But we’re looking for a value stock is going to be the lowest relative price. So the lowest market price relative to fundamentals. And we’re going to, again, sort stocks. And so the cheapest ones are going to be value. The most expensive ones are going to be growth. If we combine them together, small-cap value is taking the smallest stocks in the market, sorting them by relative price, and the smallest, lowest-priced stocks are small-cap value stocks.
Scott Trench: This is, I think, where I get tripped up, because when you talk about small-cap value, there’s so many different ways to spin that. You say, okay, first fundamental thing is price-to-earnings ratio. That’s a good starting point for value, a low price-to-earnings ratio. But then if that company has a lot of debt, you can have a low price-to-earnings ratio, but pretty bad, I would say, valuation on an enterprise level when you combine equity and debt. There’s always factors like net cash or net working capital adjustments that you can make for these businesses. There’s CapEx, and how you’re thinking about factoring in a large investment that the company’s made, which may not be compressing their earnings, but may in fact not pan out. What is the right way to do that, or what is the best-supported methodology for determining value, in your opinion, that the research supports?
Ben Felix: I’ll tell you what, the companies that are implementing products like this that are combining multiple metrics to decide how much they’re going to weight different companies, and the way that they’re doing that right now is combining multiple factors that account for a lot of the stuff that you just brought up. The 2 big companies— one of them is called Dimensional Fund Advisors, and you mentioned Avantis. Avantis sort of stemmed from— they’re an offshoot of Dimensional. Some folks left Dimensional in 2019 to start Avantis. But Dimensional is kind of the OG in the space. They created the first small-cap fund in 1980, and then they have stayed very close to academia where all this stuff has come from, and they’ve implemented all of the stuff that’s come out over time. What they do is they do measure value using price-to-book, but they also care about profitability, and then they also care about investment, which is another factor that you mentioned. So they’re not just looking at book-to-market and saying which are the cheapest companies, because that can be, you know, misleading if we care about expected returns. They’re looking for the lowest-priced companies with the most robust profitability, with the most conservative investment or growth in the book value of their assets.
Scott Trench: Perfect. So, but the challenge is now that we’ve defined the terms, we’re even more confused, because you said lowest price, lowest price relative to profitability, but how do we define profitability? So these are all kind of like circular factors here. What is the cleanest way to articulate that? How are we defining earnings in this context?
Ben Felix: Well, yeah, they’re using gross profitability as the measure for profitability, so you move up the income statement and deal with a lot of the stuff that can be messy as you go down further. That’s it.
Scott Trench: Okay, fair enough. Walk us through what good and bad looks like in the world of small-cap value factor investing, because there’s a number of firms here and people have strong opinions in the space, and I can’t tell you why one is better or worse than the other. I don’t think a lot of people can. I think you’re one of the— we’re excited to talk to you because we think you’re one of the few people who really can articulate this difference eloquently and succinctly.
Ben Felix: Yeah, it’s a difficult question, because as we’ve been talking about, the metrics do differ across companies. But if we look at, like, Vanguard does have a US small-cap value index fund, and it’s using a CRSP, which we talked about earlier, small-cap value index, and it is an index fund, so it’s just tracking an index. Now, this is neither good nor bad, but what I would say about that specific fund is that it’s not as small or as cheap as something that Dimensional or Avantis would put out. So that can be a little bit tricky, where we can have a whole bunch of funds with the name, you know, US small-cap value, but they’re not all going to be the same average market cap. They’re not all going to be the same average price-to-book, and they’re not all going to be considering multiple asset pricing factors.
Mindy Jensen: How do you know which one is the one to invest in?
Ben Felix: It depends on what exposure you want. I mean, our firm uses Dimensional. Avantis just launched ETFs in Canada. They didn’t have business here previously, so we’ll be looking at that, but we’ve been using Dimensional since they came to Canada in 2003. It’s because they’re taking everything that we know about the asset pricing literature in academia, and they’re implementing that in portfolios. We’ve talked about the main asset pricing factors, but there are all kinds of other little details and nuances that they do to make things as efficient as possible. We like that. Now, does that make it right? I mean, if somebody said that they want to invest in the S&P SmallCap 600 Value ETF because they like that index, I mean, that’s fine. We like Dimensional because they’re taking the best of academic research and putting it into a product and keeping it constantly up to date. But that doesn’t guarantee that it’s going to outperform. It doesn’t make it an objectively better product. I think a lot of stuff in this world of picking an ETF is going to come down to preferences and really perceptions.
Scott Trench: How do I get a little bit less fuzzy about the boundaries of what these earnings ratios or price-to-book value ratios or size components of these companies are? When does a company leave a fund like Dimensional’s or Avantis’ small-cap value funds, and when does it enter?
Ben Felix: That’s a very practical question. As not one of the managers of the fund, I don’t know if I have a really good answer. It is going to be different too, where Dimensional is more focused on small caps specifically, whereas Avantis will let their small cap fund drift more into mid caps. They may actually even allow mid caps in their universe. So it is going to be different, but they will have breakpoints and they will exit securities when they get to a certain point. But what exactly those are, I mean, that’s a Dimensional-level question, not a Ben Felix question.
Scott Trench: Fair enough. Well, how about for a Ben Felix-level question? What does, generally speaking, good look like? What does the research suggest ought to be some of these boundaries to stay in this world and actually get the benefits of small-cap factor investing?
Ben Felix: That’s a tough question. It’s really like how much small-cap value exposure or how small should you go? There’s no right answer to that question. It’s kind of like analogous to how much should you have in stocks versus bonds. It’s different, but it’s kind of like that. There’s no objectively right answer to that. It’s like how much additional risk are you willing to take? How much tracking error relative to the market are you willing to take? We’ve had him on a couple of times, but a while ago we had the CIO of Avantis, Eduardo Repetto, on our podcast, and we asked him who should be 100% small-cap value investor. He kind of laughed and said that you have to be a very special person to be 100% small-cap value. But again, is Vanguard’s using the CRSP Small Cap Value Index the right definition of small-cap value, or is Dimensional’s smaller and cheaper, or Avantis’ smaller and cheaper approach, better? They’re just different. They’re different exposures. If you want to capture the small-cap value premium, generally speaking, you do want to be in a smaller, cheaper, more profitable fund.
Scott Trench: One of the reasons why we’ve gotten very interested in this over the last couple of years is because CAPE, even if you make sensible adjustments like Big ERN, Karsten Jeske, does to his CAPE modifications for things like retained earnings, share buybacks, those types of things. With the CAPE ratio being very high, cyclically adjusted price-to-earnings ratio, over the last 10 years, for those who are struggling to follow here, that is giving me pause about being completely concentrated in my equity position in the S&P 500, for example. Are you seeing that interest emerge among a lot of investors who follow your channel and your work? And is that something that you worry about at all?
Ben Felix: Yeah, but I’ve been worried about it for like 10 years and the market just keeps going up. At a certain point you have to kind of just admit defeat. I don’t know. What I’ve said for a long time is that the CAPE ratio is not a reason to change your portfolio, but it does make me feel pretty good about the fact that we are tilted away from the largest and highest-priced companies. So it’s a tough signal, right? It’s a very noisy signal. We’ve looked at CAPE predictability in the US and other markets, and there are a lot of cases where you can have really high future returns from a ridiculously high starting CAPE ratio. They do eventually come down usually, but it’s just so hard to predict. And we’ve seen that, like I’ve been saying for years now, the US market, the CAPE ratio is so high, the expected return is so low, which is kind of the inverse of the CAPE. And it just hasn’t happened. The market return has continued to be ridiculously high. I mean, is that a good reason to be in small-cap value or to move away from market capitalization weighting? I do think so, but I would have trouble saying that it’s like a timing signal. Being tilted away from the largest and highest-priced companies is good, period, at any time. I don’t know if I would say it’s particularly good now. However, there are a couple of cases going back through history where the US market has had a crazy one, where leading up to the dot-com bust, the CAPE ratio was nuts. Japan has had one where their CAPE ratio got even higher up to 1989. In both cases, you had a lost decade, in the case of the US, where the US market delivered basically a 0% return for a little over 10 years, longer if you measure it in Canadian dollars. Japan, I mean, they had a crash at the end of 1989, 1990. In real terms, you still haven’t recovered from that crash. In both of those cases, the US lost decade and the Japan lost whatever that is, small-cap value in both countries performed well while the market was flat basically for a very, very long time. Again, not a timing signal. You shouldn’t shift into this strategy now, but in the past, when CAPE’s been high and returns have been low in the future, small-cap value has performed well.
Scott Trench: In the last six months, small-cap value has been on a tear. It’s up 30%-ish from Q4. It’s up 42% from this time last year, versus the S&P being up about 28% from this time last year. Does that change anything, how you feel about factor tilting towards small-cap value, given its recent exceptional performance? You’ve finally been right. You said you’ve been wrong for 10 years on the S&P 500, right? But now small-cap value has been on this tear. That’s a huge, huge outcome.
Ben Felix: Yeah, it’s been even crazier in Canada. I don’t have the number in front of me, but the performance of Canadian small-cap value has been just obscene. I mean, yeah, that’s been nice. It doesn’t change my perception. It’s nice to know that small-cap value can still outperform, because for a while there it looked like it couldn’t. So this is good validation. Glad to see a bit of a comeback. It still struggled over the last 10 or so years, although Canada is starting to pull ahead. But yeah, I don’t think that recent returns should ever change your perception of an investment strategy.
Scott Trench: One follow-up on that, though, is the Shiller CAPE ratio is by definition based on recent returns. The current price to cyclically adjusted earnings is a pricing mechanism. So when it’s high, that’s when there’s evidence that it may underperform over the next 10 years. And of course, that does not have to be true, and there’s no timing mechanism behind it. Does that at all inform the investment strategy that you guys have over at your firm in terms of how you think about asset allocation across factors? Does pricing ever come into play?
Ben Felix: No, we don’t. We’ve looked at this, and the level of predictability that you get from CAPE is just not strong enough to make asset allocation decisions. The way that we do use it is when we set our expected returns for financial planning, we do incorporate the CAPE ratio there. So we might tell clients, you need to save a little bit more if the CAPE is high, or you can spend a little bit more if the CAPE is low. But we don’t say you should get out of US stocks and into Canadian stocks based on the relative CAPE ratios.
Mindy Jensen: Ben, last year Frank Vasquez helped me walk through setting up a golden ratio portfolio, and the small-cap value fund that he put me in was AVUV. He had nothing but great things to say about this. Why does AVUV specifically come up when talking about small-cap value?
Ben Felix: I don’t know if I know who Frank is, so I don’t know why he would’ve picked AVUV, but I’ll tell you my thought on why it is relatively popular. So I mentioned Dimensional Fund Advisors. They’ve been around since 1981. They really pioneered this approach to investing. They built small-cap funds, and then research on value came out with the Fama and French paper, and then they built value funds, and then they combined them, and then they’ve since added other asset pricing factors to their portfolio construction. They do have a bunch of other stuff, like little details—the way that they trade stocks, they account for things like momentum in the recent share price, because there’s evidence behind that as a phenomenon, although it’s hard to exploit as a standalone factor. Anyway, so they’ve been doing this forever. Avantis started in 2019, where a group of people from Dimensional left, and they did something really smart strategically in launching ETFs. Because Dimensional, while they’d been around forever, did not have ETFs. Their funds were, at the time— now they have ETFs, but at the time they were only available through financial advisors. There are a lot of people out there who were Boglehead-type investors and index-type investors who were interested in factor investing, but they couldn’t use Dimensional funds without going to an advisor, which a lot of diehard DIY folks would just never do. Avantis, I think, really won over the hearts of a lot of retail and DIY investors by being the first to market to launch this type of ETF. Dimensional had decades of runway and they built a great business. It’s still a great business. They have great products, but they were not accessible to retail investors. As soon as Avantis came and said, here are ETFs, I think there was a lot of pent-up demand for that type of investment, and that really created a lot of momentum for them, specifically within the retail and DIY community. I would guess that’s why.
Scott Trench: Got it. Is there at this point a meaningful difference between the value funds offered by Dimensional and Avantis, or are they pretty close?
Ben Felix: Dimensional and Avantis would hate me saying this, but they’re pretty similar. They do have differences in how they measure stuff. Avantis uses a different measure of profitability than Dimensional. There’s a whole debate about— I can’t remember the two accounting terms, but two different types of profitability that you can use as a metric, and which one’s better. There’s debates over accruals and how that fits into measuring expected returns, and a bunch of other little details like that, how much momentum should affect implementation. So they do differ on things like that. They differ on how they treat IPOs, but realistically, they’re both tilting toward smaller, lower-priced, higher-profitability companies. They’re excluding small stocks. They grow their assets aggressively. They both have low fees, low turnover. They’re both well-managed companies and products. A lot of it comes down to preference. Even within their small-cap value funds, Dimensional is much more small, small, whereas Avantis has more mid-caps. If you care about that, you might go to Dimensional or Avantis depending on what you want. Yeah, I would have trouble saying one is just better than the other. I think they’re just different.
Scott Trench: Got it. Tell us, in a general sense—we have small-cap value—what does the research say about large-cap value, or international small, or large-cap, or international emerging market value? Where do these other factors come into play? These are all, in many cases, funds offered by Avantis and Dimensional.
Ben Felix: These asset pricing factors work everywhere. The idea that smaller, lower-priced, more profitable companies that invest conservatively, particularly among small caps, have higher expected returns is as true in emerging markets and developed ex-US markets as it is in the US. The Dimensional products that we use have those tilts toward the factors that we’ve been talking about, across all regions and across all market caps.
Scott Trench: When would you want to, for example, go from small-cap to large-cap value, though? What’s the use case or theory behind that?
Ben Felix: I would have trouble saying, let’s switch from large-cap to small-cap. I think that the big limiting factor in a lot of these strategies for actual human investors is tracking error—how much different you’re going to be from the market in terms of your returns over time. If you go 100% small-cap value, and you can see this with AVUV if you just look at its returns since inception, you’re going to get a ton of tracking error relative to the market. Sometimes you’re going to be down, sometimes you’re going to be up. In the long run, yeah, we expect it to be up. But up until recently, small-cap value in the US has gotten just obliterated. That sucks to live through. It’s not fun, and you’re questioning the whole time, is this strategy broken? Am I doing the wrong thing? And you’re underperforming. The more you get closer to the market—so if we add back in mid-caps and large caps, maybe with a value tilt—you get closer to the market and your tracking error decreases. We like to use products that start with the total market. We own all the stocks just like an index fund would, and then, across all market caps, we’re going to tilt toward the asset pricing factors that we’ve been talking about. You get a total market portfolio with those tilts across all regions, across all market caps. You still get tracking error, but not as extreme as you would have if you were just in a small-cap value portfolio.
Scott Trench: One of the most popular strategies, I think, in the FIRE community—which we talked about, which I’d love to get your thoughts on in a follow-up episode; I know you have great thoughts, very reasonable takes on the financial independence community—I think a lot of people basically stick it in VTI or VOO, a total market broad-based fund, and call it a day during the accumulation phase. And I think that’s great. I think that as folks actually approach their FIRE number, some folks just stay in there and Boglehead it forever and get very, very wealthy, so that withdrawal rate math doesn’t really matter because they’re so far beyond that number. But I think a lot of other people begin to think about what’s a different portfolio that makes sense here. And the 60/40 stock-bond portfolio is very unpopular in practice for the FIRE community because bonds offer such low yield and are so likely to destroy wealth over very long investing time horizons, like 50-plus years. So I think that’s where a lot of interest in factor investing has begun to take place. Can I reduce my risk somewhat, take a lower withdrawal rate, but actually invest for growth over that time period? Do you think that’s the right way to begin approaching the problem? And if so, do you have any guiding ideas for folks as they construct a portfolio using that philosophy?
Ben Felix: Guiding principles are tough, because again, it’s back to that analogy of how much stocks and how much bonds, how much risk do you want to take, how much tracking error can you handle. I think, in principle, what do we expect from tilting toward other factors—factors other than the market risk premium? You can’t really call it diversification, because we’re not adding new assets. It’s like you start with the market, you tilt toward the asset pricing factors. You’re getting what I would call a more reliable expected outcome, because you’re relying on more risk premiums. I mentioned the US lost decade and that Japan example, where the equity risk premium—so the VTI or the VOO—can be zero for a long period of time. There have been, if you go back through US history and other countries’ histories, extended periods of time where the stock market as a whole delivered a zero return or even a negative return, if you adjust for inflation, or risk-free assets. A lot of people who are in the FIRE community today, a lot of people who have been in VOO and VTI today, have not lived through those types of periods.
Scott Trench: I’ll even go further than you on what you’re saying here. I’ll say a lot of people in the FIRE community who have left their job and relied on their portfolio made a bad decision by keeping their money all in equities during that transition period and had a good outcome because the market went up. That’s how I’ll phrase it, frankly. And I think that’s going to catch up one day with a lot of people. And that’s where this discussion gets increasingly important. And I think people are wising up to that, and that’s why there’s a greater interest in general in factor investing, which I think is a reasonable middle-ground solution to a truly defensive portfolio, which is inappropriate for a 40-year-old with a very long time to live. I think there are real trade-offs there that require thoughtfulness.
Ben Felix: Do you want me to give you a really, really nerdy take on this?
Scott Trench: Please, yes.
Ben Felix: Okay, okay, okay. The CAPM, the capital asset pricing model, is a single-factor pricing model. A theory came out after that on the idea of something called an intertemporal capital asset pricing model, ICAPM. In the ICAPM, you don’t just care about volatility, which is what you care about with CAPM—this is a bit of a simplification—you care about when the volatility shows up. The ICAPM is one of the theoretical explanations for why the factor premiums exist, because the risks of those types of stocks show up at times when most investors don’t want them to show up. A simple example—one important point is we don’t actually know what the risks are that people care about. I asked Eugene Fama about this. He basically came up with these ideas. When he was on my podcast, I said, what are the things people care about? How do we know that? He kind of laughed. He’s like, what do you mean? Can we get inside everybody’s head and figure it out? No, we can’t know. It’s the theory. The theory is that there is some risk that people care about, although it’s hard to identify what it is exactly. If we use an example of recession risk—say value stocks, as an example, are exposed to recession risk, which means that when there’s a recession and your labor income, your job, is at risk, you’re more at risk of losing your income. If value stocks do badly at the same time, there’s a good reason that people would be willing to pay less for those types of stocks. So that is one reason there may be a value premium. Now, if you are financially independent, if you don’t have labor income risk, the optimal portfolio for you is actually the factor-tilted portfolio. The optimal portfolio for the average investor is just the market-cap-weighted portfolio, but if you’re not exposed to the same risks as the average investor, if you don’t have labor income risk, which a lot of people do have, your optimal portfolio is to tilt toward whatever the risk factor is that we’re talking about. So in an ICAPM world, there is actually a very interesting implication for people who are financially independent, people who don’t have to worry about their labor income risk. They’re also called pure wealth investors, where their only risk is their portfolio. In the theory, they are the people who should be tilting toward the factors. Is that nerdy? I don’t know.
Scott Trench: That was very nerdy. Then, just for the people in the back here who have followed the small-cap value discussion and buy that argument, what are the other factors that you’re referring to in this?
Ben Felix: Eugene Fama and Ken French, in 1993, came out with a 3-factor asset pricing model. They said assets are priced based on market risk, relative price, which is value, and size, which is, well, size. Time goes on, there are more anomalies that get identified and papers are coming out saying, oh, the 3-factor model doesn’t price this and it doesn’t price this. In 2015, Eugene Fama and Ken French came out with a new paper with a 5-factor asset pricing model. Broadly speaking, and again, there are little differences, but broadly speaking, Dimensional and Avantis are using this 5-factor asset pricing model, which is again market, relative price, size, profitability, which we talked about, and there are different ways to measure that, and investment or asset growth, growth in the book value of assets. In their 2015 paper, Fama and French do something that sort of ties it back to theory, but when I asked Gene Fama, is their 5-factor model a theoretical model or an empirical model, he’s very clear that it’s an empirical model. There’s no really strong foundational theory that says these are the factors that should be in the model, but they do use the dividend discount model and go through this step by step. If you do a couple of transformations from the dividend discount model that account for things like dividend irrelevance, and then scale the equation by book value, you get an equation that shows that relative price, profitability, and growth in the book value of assets should be related to the discount rate of the stock. It’s like a light theoretical explanation for why those specific factors ended up in their model.
Scott Trench: In a practical sense, so we follow this through to conclusion, we build a portfolio in some of these funds like AVUV, AVLV, AVIV, AVDV, and AVEM, using some of those funds, right? Very fast there. Those are ticker symbols that broadly map to the factors I think that you just discussed here, or some of the factors that you just discussed here. What’s interesting about that—I was playing around with that in prep for today’s show—is you actually get a dividend yield on the portfolio of like in the high 2s from that portfolio, not because you’re going chasing dividends, but just because that’s what they happen to yield. And that is very close to the withdrawal rate that many would argue, in that kind of low 3s range, for an early retiree. Can we get more aggressive about withdrawal rates if we implement this research, based on what you’re finding here? By the way, that’s not the yield—the earnings yield on these portfolios, which is much, much higher, which is why we’re moving towards these factors in the first place, basically the underlying theme behind it. But does that change the withdrawal rate math for early retirees, in your view, between the dividend and the earnings yield on this portfolio?
Ben Felix: I did a podcast episode years ago where we looked at a bunch of different portfolios to find the highest safe withdrawal rate. We were just messing around, but we did find that—and this is just using historical index data, not live fund data, which can be quite different, especially for small-cap value—we did find that small-cap value supported a higher safe withdrawal rate, but that was just kind of a little fun exercise that we did. Will that be true going forward? Who knows? I mean, listen, if we’re investing in these things because we expect higher returns, and I think especially if you can be a little bit flexible with your spending—like if small-cap value tanks, you’re not going to just continue mechanically withdrawing. In theory, if we’re saying that the sort of stated fact to start the conversation is that we expect higher returns from small-cap value, high profitability, low investment, it should support a higher safe withdrawal rate. Will that work out in practice? I think it’s going to depend on your ability to make adjustments to your spending over time, because these things can also be more volatile. If the market crashes in a short period of time, small-cap value can get completely smoked. COVID was an example where small-cap value got just crushed and large-cap growth actually did better in that case. If you’re pulling out your normal planned withdrawals during that time, I mean, I’d start to get worried about you. If we just think about it from the perspective of expected returns, if we do expect higher returns, then it should support a higher withdrawal rate, with a caveat that I think you have to have some flexibility in your spending, which of course the 4% rule type thinking does not allow for.
Scott Trench: Well, I think the million—or maybe much more than that—dollar question that people watching or listening to this show are going to have is, how much should I tilt towards these factors? Specifically, how much should I weight to small-cap value? If I use a Dimensional or Avantis fund, it sounds like that’s like the academic debate between VTI and VOO—pick one. This is entertainment purposes only, but it sounds like the question is, how much do I weight towards these factors, and how much more do I weight towards small cap versus international small cap, and those types of things? Obviously, that goes way past the line of what we can discuss plainly on a podcast episode, but how would you leave somebody who just listened to this, buys the argument for small cap or factor investing—how can they begin to make a decision that’s high quality around that?
Ben Felix: There’s a topic in my podcast community—we have just, it’s a free community, community.rationalreminder.ca. I think there’s like 14,000 members in there right now, and it’s very, very active. But anyway, there’s a topic in there that was from years ago called, I think, “How Much Factor Percentage and Why.” And I don’t know how many posts are in there—I can look it up. But it became this just massive topic because everyone was discussing and debating and trying to figure out the answer to your question. I don’t know if anybody ever solved it. Let me see if I can find it. I’ll tell you that the read time—here’s the answer to your question, not actually—1,396 minutes of read time to go through that entire topic, which I think is still inconclusive. Basically, what I’m saying is it’s like an unanswerable question—it just depends on your preferences and your conviction and your beliefs and what expected returns you are assigning to the different types of factors. But there is no one answer. When Avantis first launched their ETFs, I was excited too. We had taken some criticism over the years because on our podcast we would talk about this stuff, about small cap and value tilting and factor investing. Some people would say, well, this just sounds like a sales pitch because we can’t actually use the funds that you guys use at your firm. I didn’t like that, so I made a model portfolio using ETFs that anybody could use. Initially it used a couple of iShares ETFs. There was a value ETF and a small-cap value ETF. But then when Avantis launched their products, I redid it with their funds, and it was mostly Canadian-listed ETFs and then these 2 US-listed Avantis ETFs. The intention was really to, as closely and as simply and cleanly as possible, mirror the overall exposures that we have in our portfolios at PWL. That portfolio was roughly, for the equities, 75% market ETFs and 25% small-cap value ETFs. Now, it’s also worth saying that’s not how I would design it under sort of optimal conditions. I think it’s better to tilt across the full market cap spectrum, to have large-cap value and mid-cap value and all the way through, rather than just focusing on small-cap value. I used small-cap value because there are currency conversion and withholding tax considerations that I had to think about. So I was trying to minimize the dollar amount of US dollar ETFs in my model, which is why I used small-cap value, which is like a higher potency sort of form of factor exposure. But I would prefer to do what we do in our portfolios, which is tilt across the full market cap spectrum. But just as a sort of guidepost, that model portfolio was 75% total market and 25% small-cap value.
Scott Trench: Is there some meaningful reason to tilt towards small-cap value? But this is not like “go mostly into small-cap value.” Very few people would defend going mostly into small-cap value or these other various factors, away from the total market.
Ben Felix: Some people might. I mean, I mentioned our podcast community—we have some people in there who I won’t call crazy, but they’re pretty intense about their factor investing, and some of them do have all small-cap value portfolios, and that’s—they’re okay. They’re comfortable with it. They’re comfortable enough with the research and with the potential for tracking error and underperformance that they’re willing to live with that. As we’ve talked about, it has actually done well recently, but there could be periods, long periods, where it doesn’t do well. I said this earlier, but I really think that one of the biggest limiting factors for this approach to investing is your ability to withstand performance that is different from the market—not being in the US market because you were in US small-cap value, or your international small-cap value, for the last 20 years.
Mindy Jensen: It’s painful.
Ben Felix: Not that fun.
Scott Trench: Well, Ben, this has been absolutely fantastic. For the second hour of our show, we’d love to debate stock versus real estate.
Ben Felix: You good with that?
Scott Trench: Okay, all right, next time, next time, another time here. No, this has been fantastic. I learned a tremendous amount. Thank you for sharing this, and I’m going to probably make some tweaks to my portfolio based on what I’ve learned from you on this topic—you, Paul Merriman, and the originators of a lot of this research as well. So it’s a really fascinating topic. I think it’s really important. I think it’s particularly important to people who are thinking about financial independence and are early in life. Awesome.
Mindy Jensen: Yeah, I can’t wait to go in and find all those papers that you mentioned and start reading those, like really nerd out on that stuff, because I have not read those papers yet. And I’m hoping to be able to link to them on our website so that people can find them easier than I believe I’m going to have a hard time finding them. Do you have them?
Ben Felix: I’ll tell you what I can do, Mindy. I did a YouTube video recently—oh, the title’s changed, I guess we were doing some A/B testing. It’s currently called “This Paper Could Change How You Invest,” but it’s basically an overview of everything we talked about, starting from the CAPM to the 3-factor model to the 5-factor model, and then right up to the products that were created based on that research. So I can share that link with you. And then in the video description, I also have a link to all of my academic sources.
Mindy Jensen: That would be fantastic. And we’ll include those links in our show notes for this episode so that people can find them easy as well. Yeah, because I’m excited to dive into those papers.
Ben Felix: It’s very nerdy. It’s properly nerdy stuff.
Mindy Jensen: I love that.
Ben Felix: I love it.
Mindy Jensen: Thanks, Ben. All right. Well, like Scott said, this was super fun. I have to go back and listen to this without taking notes as I go, just so I can figure out exactly what it is that you were saying, because you did blast through this pretty quickly. But you gave us so much information. I am so thankful for your time today. Thank you so much.
Scott Trench: Before you go, Ben, could you tell everybody where people can find you and your community?
Ben Felix: Oh yeah, sure. So my YouTube channel is just my name, Ben Felix. I also have a podcast called the Rational Reminder Podcast, where we post pretty nerdy stuff weekly. The one we have coming out next week—I think we’re pushing the limits of what people will actually listen to in terms of nerdiness, but we’ll see. And then I do have the podcast community, community.rationalreminder.ca, which is a closed community. You do have to sign up, but it’s not paid, it’s free. It’s a really nice place where some very nerdy people have very respectful, good discussions about these kinds of topics.
Mindy Jensen: Awesome. Thank you so much, Ben, and we will talk to you soon.
Ben Felix: Thanks, guys.
Mindy Jensen: All right, Scott, that was Ben Felix, and that was absolutely fantastic. I loved everything he had to say, and now I need to go back and listen to it all again so I can really, really figure it out. This is not an episode to listen to at 2.5 speed. This is an episode to listen to at like 0.75 speed.
Scott Trench: I think Ben is absolutely fantastic. Rational Reminder Podcast is a great show I think folks should check out. I think he’s, if not the originator of the research, he is as close to it as anybody in the space. He’s met the original researchers in this area, and I think it’s just fantastic. I think his views align, broadly speaking, with many of the prominent folks that we’ve talked to, like Frank Vasquez and the Golden Ratio portfolio, like Paul Merriman, over the last couple of years. And then Bill Bengen, originator of the 4% rule, used some of this factor research to inform his updates in “A Richer Retirement,” his new book. This is not new stuff, or really that controversial stuff. It’s pretty well-established research. How it performs in the future is anybody’s guess. I think it’s particularly interesting to me. And I’ll also say that I ran that experiment, if you remember, back in Q3 of 2025, where I put $10,000 into 4 portfolios, specifically using this kind of research. So it might be a good time to check in on those portfolios if you’re interested, and do a quick update as we close out this episode.
Mindy Jensen: Absolutely, Scott. We should check in on your portfolios and see how they’re performing.
Scott Trench: Okay, so I’ve got all 4 of my portfolios pulled up here, and I’ll share my screen, my entire screen, in a moment.
Mindy Jensen: Just a reminder that this is a short-term—so far, short-term—experiment, so Scott’s performance is not indicative of future gains either, and it’s for entertainment purposes only. Of course, Scott, entertain us with your portfolios.
Scott Trench: As a reminder, what I set up was, first, a traditional stock-bond portfolio, 60/40 stocks bonds. I set this up probably early October 2025, which is also when I happened to rebalance my personal portfolio as well, not covered by these portfolios. The first one was a 60/40 stock-bond portfolio, so $6,000 started in the total stock market index fund and $4,000 started in the bond fund. Bonds have basically gone nowhere while we’ve seen a small amount of growth in the total stock market over that 6-month period. The next portfolio was just straight-up S&P 500, VOO. That portfolio has had about a 4 to 5% cumulative return over the last 6 months. So, great, almost exactly near the historical long-term averages of what you’d expect from the S&P 500 over that period. I could probably do this over 6 months actually, to be a little clearer with each of these portfolios. The next portfolio was the risk parity portfolio designed by our friend Frank Vasquez and modeled basically off Mindy’s portfolio. That portfolio has jumped about $680, or 6.8%, over the last 6 months. And the last one was my timing-the-market portfolio, where I’ve tilted essentially entirely away from large cap and towards small-cap value, international small-cap value, bonds—which are specifically held so that if the S&P 500’s, you know, the Shiller CAPE ratio goes below certain historical norms, I’ll pivot that back to the S&P 500 in VOO. And then there’s my real estate ETF, which has outpaced what we’re seeing from the S&P 500 over that 6-month period as well. So far, this portfolio, the timing-the-market portfolio, is up, but again, this is a short period of time. So this was a very simplistic expression of a little bit of a factor tilt here in AVUV, AVDV, BND, and VNQ. That’s what I got.
Mindy Jensen: Scott, I think it’s fun to experiment with these smaller amounts just to see what’s going on in different sectors of the market, especially if you are still in your growth phase and you want to see, well, I wonder how small cap would affect my current portfolio. I definitely wouldn’t recommend somebody who wants to just test it out do it with a large portion of their portfolio. But you took $40,000, split it up into 4. I took $10,000 and put it into my Frank Vasquez portfolio, my Frankenomics portfolio. I am withdrawing the equivalent of 5%, which comes out to $42 a month. And I am up—since July of last year I am up to $11,529. And that is with withdrawals equal to a total of 5% per year. And this is the Golden Ratio portfolio that Frank set me up with. So it’s fun to watch this grow. Gold has been my biggest growth for the longest time, and when I have to rebalance, I have to pull it out of gold because it keeps going up.
Scott Trench: I did not have the same—I’ve had about a 7% gain on gold in my portfolio, started in October, because I missed that huge run-up by starting that portfolio later than you did. So it’s just interesting how the timing of this—everyone will have, almost everyone will have a different experience of this, because when you create the portfolio you’re going to have different valuations. So those will normalize over very long time horizons, but that’s the fun of investing.
Mindy Jensen: And if $10,000 is too much for you to experiment with, start with $1,000. See where the growth is, see what you’re comfortable with. Because if you go in there and get obsessed like some of us are, and you’re checking it multiple times a day, you’ll see the up, down, up, down, like all day long. In some cases, it just keeps going up—that’s always fun. It just gives you more of a real-time look at what’s going on in different sectors of the market. So if there’s something you think you want to own, try it out with a tiny little bit, see what happens. All right, Scott, there are multiple different ways to determine a small-cap value fund.
Ben Felix: Yeah.
Mindy Jensen: Ben shared, I think, 3 different ways to determine the small-cap value fund. I recently wrote an article called “Stop Optimizing: When Good Enough Is the Best Financial Decision You Can Make,” talking about how people can sometimes obsess over different little factors, or different big factors, in their life. And I think determining which small-cap value fund you want to invest in falls under this optimization trap, where you’re constantly trying to get a better return and get a better return. Make a decision and stick with it. If small-cap value is the right one for you, if you want to start adding small-cap value to your portfolio, determine which fund you’re going to invest in, make the decision, and just accept it.
Scott Trench: I think the decision whether to allocate to something like small-cap value or large-cap value or international value, that’s a big decision, right? That’s going to change the course of the next couple of years in terms of the ride you’re going to experience if you decide to tilt away from the stock market, S&P 500, or total market, to those. But what’s not a big deal, that we’ve discussed in the past, is really investing between VTI and VOO, like a total stock market index fund and the S&P 500. Those correlate very closely, and I think that’s the parallel with some of these funds. I think that applies only in this good tier of value investing funds. There can be a big difference between a bad, you know, a small-cap value fund and a good one. But I think once you get to the— across a couple of good ones, those last points of optimization, yeah, begin to maybe not matter as much.
Mindy Jensen: Yes, and it doesn’t have to be an all-or-nothing scenario. If you’re trying to decide between VOO and VTI, put 50% of what you are going to allocate into each one and see which one performs better. Maybe you discover that you like VOO better or you like VTI better, then you can move the other amount in there, or move half of what was in there into the other one. I think people get really hung up on, oh, which one is the best? Here’s a news tip: you are never ever going to have the best, most optimal performance in your portfolio ever. So stop trying for perfect and focus on good enough. And if you want to get more articles just like this in your inbox, you can sign up for our newsletter at biggerpocketsmoney.com/newsletter. I would love for you to join our list. Oh, we also have more things at biggerpocketsmoney.com. We have a ton of resources. Scott has been going nuts creating resources for you, our dear listeners. They’re at biggerpocketsmoney.com/resources. We also have calculators and templates to help you accelerate your financial independence journey. So join us over there at biggerpocketsmoney.com. All right, Scott, should we get outta here?
Scott Trench: Let’s do it.
Mindy Jensen: That wraps up this fantastic episode with Ben Felix. He is Scott Trench. I am Mindy Jensen saying see ya, chia pet.
