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Can You Handle the Tracking Error?
Historical data show that small cap, low relative price, and high profitability stocks each have delivered a premium versus the market. Some investors ask why bother holding anything but stocks that check all three boxes. I respond by channelling Jack Nicholson in A Few Good Men: “You can’t handle the tracking error!”
The average returns for these stocks make a compelling case for concentrating in them. US small value high profitability stocks returned 17.1% annualised from July 1963 to July 2026, more than six percentage points greater than the broad US market at 10.9%. That’s the difference between doubling your money about every four years instead of seven.
Before getting too excited, be aware there simply aren’t many stocks fitting this definition. Stocks that are simultaneously small cap, low price-to-book, and high profitability are about as common as foods that are both healthy and delicious. As such, these stocks represent a tiny portion of the market.
The size of this group means their returns often have extreme deviations from the market. Their annualised tracking error has been 11.8%. While tracking error is an unintuitive statistic, this should crystallise things: At their worst, small cap value stocks with high profitability underperformed the market by over 72 percentage points in a 36-month period.
Applying insights from research on stock returns is like cooking with chillis. Few people have the stomach for them on their own. But incorporating them as part of a recipe can enhance a dish, just like tilting towards higher expected return stocks in a broadly diversified asset allocation can improve outcomes for investors.
Exhibit 1
US Small Value High Profitability Stocks' Excess Returns vs. the Market
1 July 1963–31 July 2026
Past performance is not a guarantee of future results.
Glossary
Basis points: One basis point equals 0.01%.
Credit default swap: A contract that acts as insurance where the seller of the swap agrees to compensate the buyer if a debt defaults.
Sovereign debt rating: An assessment of a country’s creditworthiness. Ratings are published by credit rating agencies.
Index Descriptions
Fama/French Total US Market Research Index: Fama/French Total US Market Research Factor + One-Month US Treasury Bills.
Results shown during periods prior to each index’s index inception date do not represent actual returns of the respective index. Other periods selected may have different results, including losses. Backtested index performance is hypothetical and is provided for informational purposes only to indicate historical performance had the index been calculated over the relevant time periods. Backtested performance results assume the reinvestment of dividends and capital gains. Profitability is measured as operating income before depreciation and amortisation minus interest expense scaled by book. Eugene Fama and Ken French are members of the Board of Directors of the general partner of, and provide consulting services to, Dimensional Fund Advisors LP.
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RISKS
Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. Past performance is not a guarantee of future results. There is no guarantee strategies will be successful.
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