7 reasons to be wary of small-cap value funds
Reprinted courtesy of MarketWatch.com.
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, +0.06% ) Some small-cap value funds made considerably more, around 30%; and of course some made less.
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.
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.
VISVX holds 830 companies, much more than the 436 in VIOV’s portfolio. I am not sure how this might explain the difference in 2016 performance, but it’s an important point of comparison in any two portfolios. Because the companies in the VIOV portfolio were so much smaller, then the mutual fund’s broader diversification could have hurt rather than help VISVX’s performance.
6. Sector exposure. You could also categorize this one as luck, because various industries go in and out of favor from time to time.
The portfolios of VIOV and VISVX have major differences in the way they weight various sectors. For example, in 2016 VIOV’s portfolio was overweighted in consumer cyclical stocks and underweighted in REITs, compared to VISVX.
Such differences may even out over the long term, but in any particular year they can have a meaningful effect.
7. Individual investors’ timing. This isn’t really a trait of a fund. It’s a trait of an investor.
If you bought a fund on the last trading day of 2015, made no changes through the year and sold it on the last trading day of 2016, your return should be the same as that of the fund. But this doesn’t always happen.
If you waited until February or March to buy, or if you sold in October instead of holding until the end of the year, you missed a significant part of the fund’s return.
Individual timing is usually detrimental to returns, because investors tend to buy when others are buying (hence prices are rising) and sell when others are selling (when prices are falling).
Although this factor is about you, not any fund you might own, it’s an important thing to keep in mind when you’re comparing your performance to that of a fund, or to market averages.
Now, the second question of the day: What should you do about all this?
1. When you’re comparing small-cap value funds, focus on the four long-term variables: size of companies, value orientation, expenses and portfolio turnover.
2. If you’re deciding between VISVX and VIOV, the latter (the ETF) may be a better long-term choice.
3. If you own VISVX in a taxable account, don’t sell it in order to switch to the ETF without carefully considering the tax implications.
This comparison between the ETF and the mutual fund has led me to believe that in some cases, Vanguard investors (as well as those at other companies such as Fidelity and Schwab) may be best served by portfolios that include a mix of mutual funds and ETFs, not just one or the other.
I intend to study this issue in 2017, and I may come up with a new set of recommendations.
In the meantime, if you’re following my current recommendations there is no need to make a change.
Although it’s unrelated to this topic, I hope you will check out my latest podcast, “How to Invest During a Trump Presidency.”
Richard Buck contributed to this article. Paul Merriman and Richard Buck do not own the investments mentioned in this column.