Best And Worst ETFs, Mutual Funds, And Key Holdings: Small Cap Blend Style

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 |  Includes: AEO, DGRS, FDM, IJR, IWC, PVTB, PXSC, TNA
by: David Trainer

The Small Cap Blend style ranks eleventh out of the twelve fund styles as detailed in my Style Rankings for ETFs and Mutual Funds report. It gets my Dangerous rating, which is based on aggregation of ratings of 24 ETFs and 624 mutual funds in the Small Cap Blend style as of January 29, 2014. Prior reports on the best & worst ETFs and mutual funds in every sector and style are here.

Figures 1 and 2 show the five best and worst-rated ETFs and mutual funds in the style. Not all Small Cap Blend style ETFs and mutual funds are created the same. The number of holdings varies widely (from 25 to 2200), which creates drastically different investment implications and ratings. The best ETFs and mutual funds allocate more value to Attractive-or-better-rated stocks than the worst, which allocate too much value to Neutral-or-worse-rated stocks.

To identify the best and avoid the worst ETFs and mutual funds within the Small Cap Blend style, investors need a predictive rating based on (1) stocks ratings of the holdings and (2) the all-in expenses of each ETF and mutual fund. Investors need not rely on backward-looking ratings. My fund rating methodology is detailed here.

Investors should not buy any Small Cap Blend ETFs or mutual funds because none get an Attractive-or-better rating. If you must have exposure to this style, you should buy a basket of Attractive-or-better rated stocks and avoid paying undeserved fund fees. Active management has a long history of not paying off.

Get my ratings on all ETFs and mutual funds in this style by searching for Small Cap Blend on my free mutual fund and ETF screener.

Figure 1: ETFs with the Best & Worst Ratings - Top 5

* Best ETFs exclude ETFs with TNAs less than $100 million for inadequate liquidity.

Sources: New Constructs, LLC and company filings

WisdomTree WisdomTree U.S. SmallCap Dividend Growth Fund (NASDAQ:DGRS), First Trust DJ Select MicroCap Index Fund (NYSEARCA:FDM), and PowerShares RAFI Fundamental Pure Small Core Portfolio (NYSEARCA:PXSC) are excluded from Figure 1 because their total net assets (NYSEARCA:TNA) are below $100 million and do not meet our liquidity standards.

Figure 2: Mutual Funds with the Best & Worst Ratings - Top 5

* Best mutual funds exclude funds with TNAs less than $100 million for inadequate liquidity.

Sources: New Constructs, LLC and company filings

Boston Trust & Walden Funds: Walden Mid Cap Fund (MUTF:WAMFX) and First Trust Series Fund: First Trust/Confluence Small Cap Value Fund (MUTF:FOVIX) are excluded from Figure 2 because their total net assets are below $100 million and do not meet our liquidity standards.

iShares Core S&P Small-Cap ETF (NYSEARCA:IJR) is my top-rated Small Cap Blend ETF and Royce Fund: Royce Special Equity Fund (MUTF:RSEIX) is my top-rated Small Cap Blend mutual fund. IJR earns my Dangerous rating and RSEIX earns my Neutral rating.

iShares Micro-Cap ETF (NYSEARCA:IWC) is my worst-rated Small Cap Blend ETF and Birmiwal Investment Trust: Birmiwal Oasis Fund (MUTF:BIRMX) is my worst-rated Small Cap Blend mutual fund. IWC earns my Dangerous rating and BIRMX earns my Very Dangerous rating.

Figure 3 shows that 242 out of the 2541 stocks (over 8% of the market value) in Small Cap Blend ETFs and mutual funds get an Attractive-or-better rating. However, 0 out of 24 Small Cap Blend ETFs and 0 out of 624 Small Cap Blend mutual funds get an Attractive-or-better rating.

The takeaways are: mutual fund managers allocate too much capital to low-quality stocks and Small Cap Blend ETFs hold poor quality stocks.

Figure 3: Small Cap Blend Style Landscape For ETFs, Mutual Funds & Stocks

Sources: New Constructs, LLC and company filings

As detailed in "Low-Cost Funds Dupe Investors", the fund industry offers many cheap funds but very few funds with high-quality stocks, or with what I call good portfolio management.

Investors need to tread carefully when considering Small Cap Blend ETFs and mutual funds, as this style is filled with Dangerous-or-worse rated funds. No ETFs or mutual funds in the Small Cap Blend style allocate enough value to Attractive-or-better-rated stocks to earn an Attractive rating. For exposure, investors should focus on individual stocks instead.

American Eagle Outfitters, Inc. (NYSE:AEO) is one of my favorite stocks held by Small Cap Blend ETFs and mutual funds and earns my Very Attractive rating. Over the past decade, AEO has increased after-tax profits (NOPAT) by 11% compounded annually. The company currently earns a top quintile return on invested capital (ROIC) of 17% and has had positive economic earnings for the past 15 years. Despite this profit growth, AEO remains undervalued. At ~$13/share, AEO has a price to economic book value (PEBV) ratio of only 0.8. This ratio implies that AEO's NOPAT will permanently decline by 20%. Given the company's recent NOPAT growth and excellent ROIC, such low market expectations make AEO a great buying opportunity.

Private Bancorp Inc. (NASDAQ:PVTB) is one of my least favorite stocks held by Small Cap Blend ETFs and mutual funds and earns my Dangerous rating. PVTB currently earns a bottom quintile return on invested capital (ROIC) of 5% and has generated negative economic earnings for the past six years. Over that timeframe, PVTB has only grown NOPAT by 8% compounded annually. However, PVTB's stock price has risen by ~70% this past year, making it significantly overvalued. To justify its current price of $29/share, PVTB would have to grow after-tax profit (NOPAT) by 14% compounded annually for the next 32 years and increase ROIC to 16%, a level never achieved by the company in the timeframe captured by our model. The highest ROIC that PVTB has achieved was 15% back in 2005. To believe in PVTB investors must not only think that the company could grow NOPAT by almost double the current rate, but also achieve profitability levels never seen before. I believe that such a high valuation makes PVTB a stock investors should avoid.

Figures 4 and 5 show the rating landscape of all Small Cap Blend ETFs and mutual funds.

My Style Rankings for ETFs and Mutual Funds report ranks all styles and highlights those that offer the best investments.

Figure 4: Separating the Best ETFs From the Worst Funds

Sources: New Constructs, LLC and company filings

Figure 5: Separating the Best Mutual Funds From the Worst Funds

Sources: New Constructs, LLC and company filings

Review my full list of ratings and rankings along with reports on all 24 ETFs and 624 mutual funds in the Small Cap Blend style.

Kyle Guske II contributed to this report.

Disclosure: David Trainer and Kyle Guske II receive no compensation to write about any specific stock, sector, style or theme.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.