I wrote in June about my preferred way to invest in small-cap value equities: VIOV. Have learned some things since then, especially how to figure out just how small-cap and value a given ETF actually is. So, I decided to open up the search again.
Dedicated readers may be expecting a certain format for my “preferred assets'' blog posts. So far, I’ve done nine, each trying to answer the question of how I would invest in a given asset class or sub-asset class, such as my choice of GLDM to invest in gold. Small-cap value equities are a key part of my real life portfolio and some of my test portfolios, so in June, I took a long look at VIOV, Vanguard’s S&P 600 Value Index fund.
I’ve learned some things since then, so thought it might be nice to revisit small-cap value. I’m now armed with a new tool to use: the “Factor Regression” tool on Portfolio Visualizer, which allows you to compare different tickers according to various factor models, especially the Fama-French Three Factor model. The takeaway is that you can then actually see to what degree an asset actually captures those different risk premia.
After playing with it a bit, I thought it might be instructive to re-open my search for just the right small-cap value ETF to include in a RP portfolio. Maybe through a comparison I can define what works best for the intended purposes that I lay out, and that may mean stepping away from VIOV as my preferred asset. Is there a better way to invest in small-cap value?
VettaFI lists 12 small-cap value funds, but there are some funds which track the same index in the mix so it would be redundant to do all. I’ll pare that back to five to make for a more manageable comparison.
VIOV: Vanguard S&P Small-Cap 600 Value ETF (Fund page, Barchart Summary). First on my list since it’s what I use in the test portfolios. Tracks the S&P Small Cap 600 Value Index, the same as IJS and SLYV, which are second and third by AUM.
AVUV: Avantis US Small-cap Value ETF (Fund page, Barchart Summary). Fourth by AUM, this active fund doesn’t track index. Avantis’s approach still keeps expense ratios competitive with more passive funds.
XSVM: Invesco S&P Small-Cap Value with Momentum ETF (Fund page, Barchart Summary). Eighth by AUM, this one adds on another screen for momentum. It is based on the S&P Small Cap 600 Value Index, then takes the 240 most undervalued, then divides that by taking the half with the strongest price momentum.
RZV: Invesco S&P Small-Cap 600 Pure Value ETF (Fund page and Barchart Summary). Also tracks the S&P Small Cap 600 Value Index but concentrates holdings to the one-quarter or so that have the best value characteristics.
How Will I Decide?
To start with, I’ll lay out the evaluative criteria. What exactly am I looking for?
- I want some degree of diversification from other equity funds, especially from large-cap growth equities. This is part of the “equity barbell” approach where there is a large portion in each of the two opposing types of equities, without much in the middle.
- I still want the focus to be on low-cost, broad-based index funds. I’m looking for low expense ratios, decent AUMs, and diverse holdings. I am willing to relent a bit on my usual preference for low costs, but I want to make sure I’m not heading too far over towards active management that might just capture lightning in a bottle for a stretch.
- Above all, If I’m going to go for small-cap, then I want the most “small-cap-y” fund, and if I want value, then I want it to be the most “value-y”. This is where the factor regression will show which assets epitomize these factors the most.
First Criterion: Correlation with Other Equity Funds
In a Risk Parity framework, finding asset classes that have high positive expected return and low (or negative) correlation to other asset classes is the first priority. In this search, though, I’m departing somewhat from a RP approach and taking on more of a factor investing approach to capture more variety within the equity bucket. Again, this is not strictly RP, though portfolios can be improved by investing in assets beyond just a Total Stock Market fund.
I still do want a fund that will provide a smidgen of low correlation compared to other existing equities funds, namely large-cap growth stocks. To see just how different the small-cap value funds are from those, I’ll use Portfolio Visualizer’s Asset Correlation tool to compare the small-cap value funds with Vanguard’s Total Stock Market ETF (VTI), Vanguard’s Large-cap Growth ETF (VUG), and Invesco’s Nasdaq 100 ETF (QQQ).
Not so much a clear winner here, but there is a clear loser: VBR. It’s more correlated with the other equity funds, leading to less diversification impact in your portfolio. The other four are all pretty similar. Mathematically, RZV and AVUV are a tick ahead of the other two, and then RZV inspires a bit more trust than AVUV due to its longer history.
Second Criterion: Low-cost & broad-based Index fund
Looking here for low expense ratios, and certainly nothing higher than .5%. Higher AUM and more holdings are directionally better for my purposes, as well:
Of these, VBR clearly fills the mandate of an index fund, but VIOV and AVUV are both competitive on expense ratio, and are large and broad enough. This is remarkable for AVUV, since it is an active fund, yet still manages to be competitive. The two Invesco funds are both more niche, but the expense ratios are not so high as to disqualify them by any means. With XSVM, you are getting a pretty narrow range of funds, likely as a result of the momentum screen added on to small-cap and value.
Third Criterion: Finding the “small-cap value-est”
This was the question that launched this blog post - which best captures the risk premium of smaller company stocks and the value premium of lower valuations? Using the “factor regression” tool, I can see two important facts about each asset:
- The SMB (Small Minus Big) number, which measures the asset’s tilting towards the size premium.
- The HML (High Minus Low) number, which captures exposure to the value premium.
In both cases, a higher number is better.
From this analysis, RZV is fairly clearly the fund that epitomizes what a small-cap value fund should be. It has higher numbers for both types of premia. AVUV is second best, with VBR faring the worst.
One interesting note is that the numbers shift quite a bit depending on the time frame. When comparing all five, the data goes back to October, 2019, the date of the start of the youngest ETF (AVUV). Over this almost three year stretch, XSVM is the best at capturing the size and value premia, with a figure of 1.03. Meanwhile, RZV was slightly lower for size (.91) but higher for value (.86 compared to .73 for XSVM). This is important, but given the fact that a longer data set is better for getting a true sense of how an asset might perform over the long-term and across different economic environments, I give more credence to RZV’s higher figures over 16 years.
An Additional Criterion: Best Performance
Until now, I haven’t mentioned each fund’s performance. It’s somewhat of a paradox: the research shows that investors take on more risk with small-cap value stocks and can thus expect higher returns in the long run. But for a given stretch of time, even a decade, this premium may not show up. Since 2009 or so, this has been the case: large-cap growth has outperformed small-cap value and some have started to doubt whether the small-cap and value premia actually exist. Over the past decade or so, the purer the small-cap value fund is, the worse we can expect it to have done over. Because of that, poor performance over this stretch may actually have a benefit - lower valuations now offer more potential for appreciation when the size and value premia finally appear in full (if they do!).
Yes, it’s complicated. So, take these with a grain of salt.
The Compound Annual Growth Rates, standard deviations and Sharpe ratios below, when starting with the fund’s inception dates, are a reflection of that starting period and how small-cap value in general did during that time period. Three of the funds date back to before the Global Financial Crisis, creating a statistical hole that VIOV and AVUV didn't experience.
To provide a more apples-to-apples comparison, I then looked at the five funds since February 1st, 2020, just before the Covid-19 shock. This two and a half year period has been a good one for small-cap value, so perhaps here we get a sense of just how well this asset class can do when it is in favor. Don’t make the mistake of thinking this is typical for the asset class, though.
So, After All That…What’s the new Preferred Asset for Small–Cap Value?
Let’s invert the question and start eliminating some candidates to get to the answer.
We can definitely take VBR off the table. It has the most correlation to other equities that you might want to pair with small-cap value, has the weakest tilting towards size and value, and hasn’t performed all that well even during a good time for this type of equity. It does have the lowest expense ratio, the largest AUM, and the broadest reach, but those are small consolations.
Pains me to say this, since it means retracting an earlier blog post, but I don’t think VIOV is the answer, either. On its plus side, it has a low expense ratio and its correlation numbers are on the low side. It is decent at capturing the size premium, but not the value premium. It’s performance has been “meh.” Not a bad fund to own, by any means, and I don’t think I’ll sell my shares in my taxable account, though I will send new contributions elsewhere.
Where though? The remaining three are all pretty close, so eliminating them is tricky. All three have pretty much the same correlation numbers, so that’s a wash. The noticeable impact on any of the three in a given portfolio such as the Golden Butterfly or the RPC Stability would be pretty muted.
AVUV is the largest by AUM and the cheapest by expense ratio, and would be at less risk of blowing up compared to the other two. If staying firmly in the realm of passive investing is important to you, then AVUV might be the choice. It also has been the best performer since February, 2020, if you believe that indicates something about its future prospects.
The two Invesco funds remaining are a toss-up. They are both much smaller funds, and I have seen enough of these very small funds get closed down (giving you a tax hit as they cash out and create a taxable event) to be wary of them. They have both performed well recently, and all things considered, their expense ratios are fine considering what they do to maintain high exposures so size and value. XSVM has the added screen of “momentum,” which theoretically adds another risk premium for investors and should in theory lead to better returns.
RZV is the best at fulfilling the most important objective I seek in small-cap value funds: that they truly be small-cap and truly value. RZV is the clear winner for both. At the same time, its very small AUM even though it has been around for 16 years gives me pause. I am wondering if this is just timing - it starts in 2006, takes a huge hit, and then its numbers seem to be in the gutter for years, never able to wash off the bad luck of starting in 2006. If it were to come along now, with a clean slate, it might be the belle of the ball and surpass AVUV’s figure. Who knows?
In all, I think I’ll go with AVUV for the majority of my new contributions to small-cap value. I might mix in a bit of RZV later to keep things interesting, but AVUV is where I'll start.
Note: Big thanks to reader, friend and fellow investment geek AZ for inspiring this post by telling me about XSVM and prompting me to take a closer look at the Factor Regression tool. It really expanded my perspective!