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Want to beat the FTSE 100? Read this now

Investors try to beat market indices, such as the FTSE 100 or the S&P 500, in many different ways.

Some investors swear by value investing, which focuses on stocks with attributes such as low price-to-earnings ratios and low price-to-book ratios. At the same time, others focus on growth investing, which pays less attention to valuation multiples and focuses more on revenue and earnings growth. You can also break these categories down by market capitalisation, and you’ll find investors that prefer to focus on areas such small-cap growth or large-cap value.

Is one of these categories more effective at generating market-beating returns over the long term? Quite possibly, according to research from US investment house Dimensional Fund Advisors.

Small-cap value has smashed the S&P 500

Last year, Dimensional calculated long-term returns (80 years) from the US stock market, by investment category. Here are the performance figures the analysts came up with:

Asset Annualised Return
Fama/French US Small-cap Growth 8.8%
Fama/French US Large-cap Growth 9.6%
S&P 500 Index 10.3%
US Large-cap Value Index 12.5%
US Small-cap Value Index 15.2%

Source: Dimensional Fund Advisors
Data from 1927 to the end of 2016

Now obviously, this data relates to US stocks and the S&P 500 Index, which are very different from UK stocks and the FTSE 100 Index. The data also doesn’t include the bull-run that US large-cap growth stocks, such as Apple, Amazon and Facebook, have enjoyed over the last 21 months. However, looking past these issues, the performance data does suggest that small-cap value stocks have performed very well over the long term, outperforming other strategies such as large-cap growth, or simple index tracking.

Outperformance

Why has small-cap value performed so well over time?

Well for starters, smaller companies tend to grow faster than larger companies. That potentially means more capital growth for investors and faster-growing dividend payouts. Furthermore, these companies are also often under-researched, meaning they may not be priced accurately by the market.

Second, value investing, where assets are bought when they are trading below their ‘intrinsic’ value, is a proven investment strategy that tends to generate excellent results over the long term, even if there are times when the style will be slightly out of favour (like now).

When you combine the art of value investing with a smaller company focus, the results can be impressive.

Risks

Of course, no investment strategy is perfect and there’s no guarantee that a small-cap value strategy will generate strong returns in the future. Often, a strategy will work well for a year or two, and then underperform for a while.

It’s also worth remembering that smaller companies are generally more volatile than larger companies, and that means higher risk. So you don’t want to be overexposed to this category of shares.

Yet looking beyond these risks, the statistics make a pretty good case for at least having some exposure to small-cap value stocks in your portfolio. For long-term investors, a small allocation to small-cap value as part of a diversified portfolio could be an excellent strategy, in my view.

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Edward Sheldon has no position in any shares mentioned. John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. The Motley Fool UK owns shares of and has recommended Amazon, Apple, and Facebook. The Motley Fool UK has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.