7 reasons to be wary of small-cap value funds
Reprinted courtesy of MarketWatch.com
Published: Jan. 24, 2017
To read the original article click here
For more than 20 years I have been recommending that investors of all ages put 20% of their equity portfolios into small-cap value funds and/or small-cap value ETFs.
Last year was a great one for small-cap value investors, and those who had taken my advice had ample reason to be glad they had done so.
The average small-cap value fund (including ETFs) gained 26% in 2016. (That’s more than twice the 11.8% return of the Standard & Poor’s 500 Index SPX, -0.23%. ) Some small-cap value funds made considerably more, around 30%; and of course some made less.
One of those that made less than the average was the Vanguard Small Cap Value Fund VISVX, +1.99%, up “only” 24.7%. This fund has been a bedrock part of my recommendations since the mid 1990s, and of course I was curious about why it turned in a below-average result.
I became even more curious about this upon learning that Vanguard’s Small Cap 600 VIOV, -0.24% , an ETF I recommend in my Vanguard ETF portfolio, made 30.1% last year, notably above average.
Same management company. Same asset class. Significantly different results in this particular year.
I doubt very many investors in VISVX (the mutual fund) are crying in their soup about their sub-par performance. But still, when you are relying on a well-run company like Vanguard to get the returns of an asset class, you don’t expect to be trailing the averages.
All this leads to the question of the day: Why does one small-cap value index fund do appreciably better or worse than another? Later, I’ll get to the second question of the day: What, if anything, should you do about it?
I think the answer contains some good lessons on how investing works, particularly in this particular asset class.
There are seven variables that can be responsible for parts of such a difference. It’s worth your while to understand them.
1. The size effect. Small-cap value stocks, by definition, represent smaller-than-average companies. Small is better (by and large) than big. And smaller is better than not-quite-so-small.
If everything else is equal, a portfolio with smaller companies should perform better, at least in a year like 2016 when small companies outperformed larger ones in general.
This helps explain why VIOV outperformed VISVX; the ETF’s average portfolio holding was a company with $1.4 billion in assets — less than half the size of VISVX’s average company, $3.25 billion.
2. The value effect. Some companies have deeper value discounts (usually measured by the ratio of a stock price to the company’s book value) than others. In a year like 2016 when value companies outshine growth stocks, deeper value (indicated by a lower ratio) should be an advantage.
And that proved to be the case. VIOV’s higher performance came with an average price-to-book ratio of 1.65, showing slightly more value orientation than the 1.75 of VISVX.
Read: The best-performing stock sector for 87 years
3. Expenses. When other things are equal, a fund with lower expenses will always have a greater return than one with higher expenses.
Both VIOV and VISVX have operating expense ratios of 0.2%, a suitably low figure. So in this case, they are equal — and considerably better than average: The average small-cap value ETF expense ratio is 0.37%; for mutual funds, the figure is 1.31%.
4. Portfolio turnover. Beyond the operating expense ratio, fund investors also pay more when a fund buys and sells its companies more rapidly. Higher turnover, in other words, adds additional expenses.
This helps make the case for funds and ETFs that follow indexes. Actively managed small-cap value funds average turnover that’s two to four times as high.
In this instance, VISVX had an advantage last year, with turnover of only 16%, compared with 42% for VIOV. The average small cap value fund and ETF had an average turnover of 78%.
Those four factors make the most difference when comparing one fund against another.
But three others can matter quite a bit as well.
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