Why not just hold the total market?
The total US stock market (VTI, ITOT) is a perfectly reasonable equity holding. It's low cost, highly diversified, and captures market returns faithfully. Most investors who hold just VTI will do fine.
Risk parity equity sleeves consistently split between large cap growth and small cap value rather than holding the total market. The reason: small cap value has historically delivered a return premium over total market indexes — and that premium is rooted in durable, well-documented academic research.
Fama and French: the three-factor model
In 1992, Nobel Prize-winning economists Eugene Fama and Kenneth French published research showing that most of the variation in stock returns could be explained by three factors, not just one:
Small cap value stocks — companies that are both small and cheap relative to their book value — capture the size premium and the value premium simultaneously. Over decades of data, across multiple countries and markets, small cap value has outperformed the broad market by a meaningful margin.
Why the premium exists (and persists)
Two competing explanations have been offered for why small cap value outperforms:
The risk explanation: Small cap value companies carry higher risk of financial distress. They're smaller, have less access to capital markets, and are more vulnerable to economic downturns. Investors demand higher expected returns as compensation for holding riskier companies. The premium is real — but so is the risk.
The behavioral explanation: Institutional investors systematically underweight small cap value because it's harder to cover and less glamorous than growth stocks. Large mutual funds and index funds are overwhelmingly concentrated in large caps. Small cap value is under-owned and therefore under-priced relative to its fundamentals.
Both explanations have empirical support, and both suggest the premium is unlikely to fully arbitrage away. The premium has persisted through every decade since Fama and French documented it, across US markets, international markets, and emerging markets.
Small cap value and large cap growth tend to rotate. Growth stocks dominated the 2010s. Value decades have historically followed growth decades. Holding both in equal measure means you're always in the part of the equity market that's currently favored — and you're capturing two distinct return premia rather than just one.
How risk parity portfolios use small cap value
In the Golden Ratio portfolio, the 42% equity allocation is split evenly: 21% large cap growth (VUG or IVW) and 21% small cap value (AVUV, VIOV, or DFSV). This isn't a market-cap-weighted approach — it's a deliberate equal-weight split to balance exposure across the equity factor spectrum.
Large cap growth and small cap value are themselves somewhat uncorrelated over shorter periods. During the 2010s bull market, large cap growth (dominated by mega-cap tech) dramatically outperformed. During value decades, the reverse tends to be true. Holding both means you're not fully dependent on either cycle.
Choosing a small cap value fund
| Ticker | Fund | Approach |
|---|---|---|
| AVUV | Avantis US Small Cap Value ETF | Actively managed factor tilts. Strong factor exposure, launched 2019. The most popular choice among factor-aware investors. |
| VIOV | Vanguard S&P Small Cap 600 Value | Passive index. Lower cost, longer track record. S&P 600 has a profitability screen that reduces "junk" exposure. |
| DFSV | Dimensional US Small Cap Value ETF | Direct indexing approach with factor tilts. Similar philosophy to AVUV with Dimensional's methodology. |
All three are solid choices. The difference between them is far less important than the decision to hold small cap value at all. Don't let fund selection analysis prevent you from making the allocation. Pick one and stay consistent.
A note on parsing small cap funds
Not all "small cap" funds are the same. A fund that tracks the Russell 2000 index (like IWM) holds a large percentage of unprofitable companies — often called "junk" small caps. The Russell 2000 doesn't screen for profitability, which dilutes the value premium.
The small cap value premium is concentrated in profitable small cap value companies. Funds like AVUV, VIOV, and DFSV apply screens that reduce or eliminate unprofitable companies. A generic small cap fund like IWM does not capture the same premium as a targeted small cap value fund.