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By Alex Bryan

Small-cap value historically has been the best-performing segment of the United States equity market, and Vanguard Small Cap Value ETF (VBR) offers investors a low-cost way to take advantage of this value premium. It invests in the cheaper and potentially higher-returning half of the U.S. small-cap market. However, VBR is not for the faint of heart. Most small-cap stocks lack sustainable competitive advantages and are typically more volatile than the broad market. Within this segment, value stocks tend to carry slightly greater risk than their growth counterparts. Consequently, VBR is a suitable small core holding for long-term investors with a relatively high tolerance for risk.

Value stocks tend to carry relatively high business risk, poor prospects for growth, and may remain out of favor for years. Yet, investors tend to penalize these companies too much by extrapolating recent performance too far into the future. This myopic focus can push prices below their fair values. Consequently, value stocks have generated better risk-adjusted returns than the market over the long run. Their depressed valuations can provide a margin of safety and offer attractive upside if they exceed expectations, which are low to begin with.

Because Vanguard Small Cap Value ETF covers approximately half of the small-cap market, small-blend stocks dilute its value tilt. However, this fund has less overlap with its growth counterpart, Vanguard Small Cap Growth ETF (VBK), than rival value and growth funds based on the Russell 2000 and S&P SmallCap 600 indexes. Even still, VBR and VBK were 0.96 correlated over the past five years. VBR's correlation with the broad Vanguard Small Cap ETF (VB) over that same span was even higher (0.99). Therefore, VBR does not offer significant diversification benefits to investors who already have broad exposure to U.S. small-cap stocks. It does, however, provide better diversification for investors who already have heavy exposure to large-cap stocks or funds.

Vanguard announced that it is switching Vanguard Small Cap Value ETF's index from the MSCI US Small Cap Value to the CRSP US Small Cap Value, citing potential cost savings. However, the fund will continue to offer very similar exposure. In order to prevent arbitragers from taking advantage of this switch, Vanguard has not released the date when this change will go into effect.

Fundamental View
In the U.S., small-cap value stocks (low price/book) have outpaced their growth counterparts by a whopping 6% annualized from 1927 through 2012. While it would be unreasonable to expect small value to outpace small growth by that wide of a margin going forward, there is reason to believe the value premium will persist. Many efficient market advocates attribute value's superior performance to additional risk. This risk story is plausible. Relative to their growth counterparts, value stocks tend to have lower profit margins, dimmer growth prospects, and higher debt burdens. Additionally, these stocks tend to slightly underperform during market downturns (the post-tech bubble correction is a notable exception). However, value stocks still offer better risk-adjusted returns. There is a growing pool of evidence that suggests investors tend to extrapolate past growth too far into the future and discount the impact of competition. This creates systematic mispricing that may partially explain the value premium. Although small-blend stocks dilute the fund's exposure to the value premium, its style tilt should modestly boost returns over the long run.

Some researchers and practitioners argue that small-cap stocks offer a smaller yet distinct premium from value. While small-cap stocks have historically outperformed their large-cap counterparts, this effect is largely isolated to value stocks. In fact, small-cap growth stocks historically have underperformed their large-cap counterparts. Therefore, the value effect largely subsumes the small-cap premium. Small-cap value companies are frequent buyout and acquisition targets. The premiums from these deals can help boost returns and may contribute to small-cap value stocks' superior long-term performance.

In the near term, the U.S. economic recovery should continue to benefit the fund's holdings, particularly if acquisition activity picks up. The U.S. economy has been surprisingly resilient over the past few years. Households and companies have reduced their leverage in recent years, consumer spending is reasonably healthy, inflation is low, manufacturing activity and oil production have picked up, and the unemployment rate has continued its gradual decline. Renewed strength in the housing market could continue to drive the recovery forward and further bolster consumer spending.

While valuations have run up a bit during the past few months, small-cap value stocks still look reasonably priced. As of the end of March, the MSCI US Small Cap Value Index was trading at 15.1 times trailing earnings, which, while not a bargain, looks cheap compared with the MSCI US Small Cap Growth Index (trading at 21.5 times earnings). Value stocks warrant a greater margin of safety than their growth counterparts because they tend to carry greater business risk. However, this large valuation gap should give small-cap value stocks an edge over the long run.

Portfolio Construction
Vanguard is moving Small Cap Value ETF from the MSCI US Small Cap Value Index to the CRSP US Small Cap Value Index. CRSP defines small-cap stocks as those representing the 85th to 98th largest percentile of the U.S. stock market. It then assigns composite value and growth scores to each of these stocks using a multifactor model. The growth factors include projected short- and long-term earnings per share growth, three-year historical earnings and sales per share growth, current investment/assets, and return on assets. CRSP evaluates value on book/price, forward and trailing earnings/price, dividend yield, and sales/price. It fully allocates stocks with the most dominant value characteristics to the small-cap value index until it represents half the assets in the small-cap market.

While MSCI applies similar index construction rules, the new CRSP index likely will reduce the fund's turnover. In contrast to MSCI, CRSP keeps 100% of each stock in its respective style index until it passes through a buffer zone. At that point, CRSP only moves 50% of the stock from one style index to the other. If the stock stays on the opposite side of the buffer zone at the following quarterly review, CRSP will transfer the remaining half. This approach should mitigate turnover where it does not significantly improve the fund's style purity.

Fees
Vanguard Small Cap Value ETF charges a low 0.20% expense ratio, which currently makes it the cheapest small-value fund on the market. Acquired fund fees represent 0.10% of this expense ratio. These are indirect expenses that the fund incurs through its ownership of investment companies, including business development companies. Acquired fund fees do not go into the fund's net asset value calculation. Vanguard recently recalculated the fund's acquired fund fees, which reduced the expense ratio to 0.20% from 0.21%. The fund generates ancillary income through securities lending, which largely offsets its expenses. Over the past five years, VBR nearly matched its benchmark net of fees. It also offers good liquidity, which keeps the costs of trading low.

Alternatives
iShares Russell 2000 Value Index (IWN) (0.37% expense ratio) climbs further down the market-cap ladder than VBR and has less mid-cap exposure. Despite its high expense ratio, IWN is the largest and most liquid small-value ETF available.

iShares S&P SmallCap 600 Value (IJS) (0.29% expense ratio) also may be a suitable alternative. In contrast to Russell and MSCI, S&P applies modest screens for quality. Relative to VBR, IJS has a smaller financials stake and greater exposure to the industrial and consumer cyclical sectors. While IJS remains true to its market-cap mandate, nearly one third of its portfolio overlaps with iShares S&P SmallCap 600 Growth (IJT), so it may not be ideal for style purists.

Investors looking for purer style exposure might consider iShares Morningstar Small Value Index (JKL) (0.30% expense ratio). JKL targets the cheapest third of the U.S. small-cap market. Consequently, it includes fewer small-blend stocks than VBR. PowerShares FTSE RAFI US 1500 Small-Mid (PRFZ) (0.39% expense ratio) provides an alternative way to tilt toward value. It weights holdings on fundamental measures of economic size, such as sales and book value. This approach gives PRFZ a contrarian bent that enables it to capitalize on temporary market mispricings.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

Source: Small Value's Best Bargain