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% |
iShares Inc. S&P SmallCap 600 Value Index Fund | 1.58 | 1780 | 0.25% | |
iShares Morningstar Small Value Index Fund | 1.64 | 2651 | 0.30% | |
Rydex ETF Trust S&P Midcap 400 Pure Value ETF | 1.01 | 2421 | 0.35% | |
Rydex ETF Trust S&P Smallcap 600 Pure Value ETF | 0.82 | 533 | 0.35% | |
SPDR S&P 600 Small Cap Value ETF | 1.58 | 1780 | 0.27% | |
Vanguard Small-Cap Value ETF | 2.15 | 3526 | 0.12% | |
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% |
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.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
