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How to actually invest in small-cap quality stocks

There’s no mutual fund or ETF, so you’ll have to improvise

If you’re an investor, I’ve got some good news, some bad news, and two more batches of good news. Which do you want first?

Let’s start with the first piece of good news: As I reported last week, there is a little-known investment strategy that has beaten the pants off the rest of the stock market for at least 50 years, and has done so pretty consistently, and there seems no obvious reason why it should cease doing so in the future.

That strategy is to invest in stocks of companies that are both “small” and “high quality.” “Small” generally means their market value is below a few billion dollars, though the definition varies somewhat. “High quality” in this situation is not simply a matter of subjective opinion: It means the companies meet certain mathematically measurable standards, and have stable businesses, good balance sheets, and consistently high returns on equity.

According to research by fund firm AQR Capital published recently, such firms have outperformed the broader stock market indexes by about five percentage points a year over time — a staggering outperformance.

To put this in context, if you invested $100 for a 20-year period in stocks and earned, say, 7% a year on average, you’d end up with nearly $400. But if you earned five percentage points more per year, or 12%, you’d end up with nearly $1,000.

Dollar Crimps Profits for U.S. Multinationals

OK, so that’s the first item of good news.

The bad news is that there is no simple mutual fund or exchange-traded fund you can buy that will give you a broad basket of small-cap quality stocks. Note that regular “small cap” or “small-cap value” or “small-cap dividend” funds do not qualify. Such funds include a lot of “low quality” stocks — and, according to the research, such stocks will both drastically cut your performance, and produce a lot more volatility, over time.

Note that the new batch of “quality” or “quality factor” funds being launched don’t qualify either. Such funds are heavily, indeed massively, weighted towards jumbo-cap stocks such as Apple AAPL, +0.24% .

In other words, when it comes to broadly based mutual funds and exchange-traded funds, you can have small cap without quality, or quality without small cap, but not small-cap quality. Bummer.

I asked MSCI, the index people, if they have a small-cap quality index. They don’t.

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