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Which funds should investors purchase to gain exposure to small cap value stock returns? Why should investors seek small cap value investments at all?

The Case for Small Cap Value

The value effect and the small firm effect are famous market anomalies. In a nutshell, the value effect is the observation that over long periods of time value stocks have outperformed growth stocks. The small firm effect is the observation of how small cap stocks have outperformed large cap stocks over long periods of time. The discovery of these phenomena by Fama and French won a Nobel Prize in economics and renewed investor interest in small cap stocks and value stocks.

Fund Evaluation

Investors can benefit from the small firm effect and the value effect by buying firms with low market capitalizations and low price-to-book ratios. Investors seeking exposure to small cap value stocks have many funds to choose from. They should select small cap value funds using the following criteria:

Low expense ratios. The less that investors pay in fund-level fees, the more they keep.

Holdings with low price-to-book ratios. These funds should have value holdings, with lower price-to-book multiples being better. Essentially, the deeper the discount, the greater the value effect.

Holdings with low market capitalization. These funds should hold small cap firms. There is even a micro cap effect, which seems to indicate that the lower the firm capitalization, the greater the firm size effect.

Financially strong holdings. Funds should be biased towards stocks with stronger financial positions that can weather bad times. Funds with more holdings which score as "safe" according to the Altman Z-score metric are preferable to funds with weaker holdings.

A collection of small cap value funds with expense ratios under 0.50% were evaluated based on their top 25 holdings. Key attributes of these funds and their holdings are listed below:

Ticker

Fund

Average P/B

Market Cap Average ($Millions)

Expense Ratio

DFFVX

DFA U.S. Targeted Value

1.28

4050

0.38%

DFTVX

DFA U.S. Targeted Value Ptf Cl R1

1.28

4050

0.49%

DTMVX

DFA Tax-Managed U.S. Targeted Value Portfolio

1.48

4085

0.45%

IJS

iShares Inc. S&P SmallCap 600 Value Index Fund

1.58

1780

0.25%

JKL

iShares Morningstar Small Value Index Fund

1.64

2651

0.30%

RFV

Rydex ETF Trust S&P Midcap 400 Pure Value ETF

1.01

2421

0.35%

RZV

Rydex ETF Trust S&P Smallcap 600 Pure Value ETF

0.82

533

0.35%

SLYV

SPDR S&P 600 Small Cap Value ETF

1.58

1780

0.27%

VBR

Vanguard Small-Cap Value ETF

2.15

3526

0.12%

VIOV

Vanguard S&P Small-Cap 600 Value ETF

2.04

1897

0.20%

VISVX

Vanguard Small-Cap Value Income Fund/Investor

2.15

3526

0.37%

VTWV

Vanguard Russell 2000 Value ETF

1.57

2336

0.20%

RZV, the Rydex S&P Small Cap 600 Pure Vale fund is the best pick for stocks with low capitalizations and PB ratios. Better yet, this fund has the smallest fraction of its 25 top holdings classified as "distressed" by the Altman Z-score:

Ticker

Distressed

Grey Zone

Safe

Average D/E

DFFVX

40.5%

23.6%

32.4%

0.52

DFTVX

40.5%

23.6%

32.4%

0.52

DTMVX

48.1%

11.7%

24.1%

0.52

IJS

44.3%

17.9%

37.8%

0.57

JKL

72.1%

8.1%

15.6%

1.16

RFV

42.0%

21.8%

26.9%

0.67

RZV

28.7%

25.6%

37.8%

0.82

SLYV

44.3%

17.9%

37.8%

0.57

VBR

55.6%

19.8%

16.9%

1.00

VIOV

31.9%

16.0%

48.1%

0.73

VISVX

55.6%

19.8%

16.9%

1.00

VTWV

82.5%

10.4%

7.1%

1.12

RZV's 25 top holdings have an average debt-to-equity ratio that is in the middle of its peer group, further indicating that its deeper value and smaller holdings do not come at the cost of more extreme risks.

Fund Selection

RZV is an excellent fund pick for investors seeking small cap value investments. Like any of the funds listed here, RZV takes most of the work out of small cap value investing by allowing investors to buy a diversified portfolio of smaller firms in one trade. However, RZV is a better small cap value pick than the other funds because its holdings are more cheaply valued and smaller. Better yet, its holdings are at the top of its peers in terms of safety. Investors should consider RZV as a way to gain small cap value exposure in their portfolios.

Please read the article disclaimer.

Source: Selecting The Best Small Cap Value Funds