The Third ETF You Should Buy

| About: Vanguard Russell (VTWO)

Summary

I recently reviewed the Seeking Alpha ETF Investing Guide and decided to implement it for a portion of my portfolio.

This article reviews VTWO, the third ETF in the core portfolio of Seeking Alpha’s ETF Investing Guide.

VTWO is a good ETF for the small-cap portion of most investor’s Core ETF portfolio. Several other good options are also discussed.

The Seeking Alpha ETF Investing Guide

I recently reviewed the Seeking Alpha Investing Guide and decided to allocate part of my portfolio to a core portfolio of ETFs, similar to that suggested by the guide. I do not intend to completely switch course from my current allocation but to set up a separate core portfolio of ETFs and to allocate a majority of my investments to this Core ETF portfolio over time.

After reviewing the investing guide, I drafted a procedure for implementing the suggestions of the guide. Currently I am reviewing each of the suggested ETFs to determine which to buy. This article focuses on the U.S. small-cap portion of the Core ETF portfolio and the Vanguard Russell 2000 ETF (NASDAQ:VTWO).

Vanguard Russell 2000 ETF - Investment Synopsis

Vanguard Russell 2000 ETF invests in stocks in the Russell 2000 Index, a broadly diversified index predominantly made up of stocks of small U.S. companies, representing about 8% of the U.S. market. VTWO seeks to closely track the index's return, which is considered a gauge of small-cap U.S. stock returns. VTWO is more appropriate for long-term investors.

Performance of the Russell 2000 compared to the S&P 500 since August 31, 1987

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Source: Yahoo Finance (2/1/2016)

The chart above shows that over the last 18 plus years (all the data that Yahoo finance had for the Russell 2000, which was far more data than was available for VTWO) the Russell 2000 (the blue line) is up 504%, while the S&P 500 (the red line) is up 670%

Performance of VTWO compared to the S&P 500 over the last 5 years

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Source: Yahoo Finance (2/1/2016)

Over the last five years, VTWO (again the blue line) tracked the S&P 500 fairly closely, although since VTWO peaked in mid-2015, it has fallen much more sharply than the S&P 500.

When setting up a Core ETF portfolio and making an initial allocation, an investor may want to consider whether they believe the U.S. small-cap underperformance will continue in both the short and long term. Depending on their conviction, they may want to under or over-weight this sector.

Equity characteristics of VTWO vs large-cap and small-cap ETFs

VTWO

Vanguard S&P 500 ETF (NYSEARCA:VOO)

Vanguard Mid-Cap ETF (NYSEARCA:VO)

Number of stocks

1999

503

365

Median market cap

$1.7 billion

$81.0 billion

$10.8 billion

Price/earnings ratio

33.8

20.5

26.1

Price/book Ratio

2.1

2.8

2.6

Return on equity

10.7%

18.5%

15.6%

Earnings growth rate

10.8%

9.2%

11.6%

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Source: Vanguard (as of 12/31/2015)

The equity characteristics above, provide a comparison of Vanguard's small cap ETF with Vanguard's S&P 500 and Vanguard's mid-cap ETF. What stands out to me is VTWO's significantly higher price/earnings ratio and lower price/book ratio and return on equity percentage. The valuation ratios have fallen since they were calculated by Vanguard as of December 31, 2015, but the price/earnings ratio remains high.

Top 10 holdings

Source: Vanguard (as of 12/31/2015)

VTWO's top ten holdings make up approximately 3.1% of total holdings. Because the Russell 2000 uses a market-cap weighting structure, the larger companies have a larger weighting.

Equity sector diversification

Source: Vanguard (as of 12/31/2015)

VTWO's largest stock holdings are in the financial sector. Investors setting up a core portfolio of ETFs will probably want to reduce their holdings of individual stocks, particularly in sectors where both the ETF and the investor are heavily invested.

ETFs in the U.S. small-cap category

Symbol

Fund Name

AUM ($MM)

Expense Ratio

IWM

iShares Russell 2000 ETF

24,607M

0.20%

IJR

iShares Core S&P Small-Cap ETF

15,887M

0.12%

VB

Vanguard Small Cap ETF

10,588M

0.09%

SCHA

Schwab U.S. Small-Cap ETF

2,770M

0.08%

IWC

iShares Micro-Cap ETF

715M

0.60%

VTWO

Vanguard Russell 2000 ETF

508M

0.15%

FYX

First Trust Small Cap Core AlphaDEX ETF

445M

0.63%

SLY

SPDR S&P 600 Small Cap ETF

390M

0.15%

RWJ

RevenueShares Small Cap ETF

265M

0.54%

DWAS

PowerShares DWA SmallCap Momentum Portfolio ETF

243M

0.60%

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Source: Seeking Alpha (as of 2/1/2016)

Above is a list of the top 10 small-cap ETFs, listed by assets under management (AUM). As the table shows, VTWO is the sixth largest U.S. small-cap ETF by AUM and there are three ETF's in the sector with lower expense ratios, discussed further below. For those that want to do further research, additional detail on these ETFs is available on Seeking Alpha's ETF Hub.

Expenses and dividend yield

VTWO's expense ratio is 0.15%, this is well below the average expense ratio of similar funds. Of the top ten U.S. small-cap stock ETFs listed above, iShares Core S&P Small-Cap ETF , Vanguard Small Cap ETF and Schwab U.S. Small-Cap ETF have lower expense ratios.

IJR seeks to track the investment results of the S&P SmallCap 600, which may be a narrower index than some people want for their allocation to small-cap stocks. VB tracks the CRSP U.S. Small Cap Index, which includes U.S. companies that fall between the bottom 2%-15% of the investable market capitalization and was made up of 1,481 companies as of December 31 2015. VB's structure may lead to some overlap with the mid-cap ETF in an investor's portfolio. SCHA seeks to track the Dow Jones U.S. Small-Cap Total Stock Market Index. The Dow Jones U.S. Small-Cap Total Stock Market Index is composed of stocks ranked 751-2500 in market cap. Similar to VB, SCHA's structure may lead to some overlap with the mid-cap ETF in an investor's portfolio. Any of these ETFs could be used to rotate the small-cap portion of your portfolio into, when tax loss selling.

Given the relatively high price of the global equity markets today and particularly U.S. small-cap stocks, it is likely that future returns may be lower than those recently experienced. In this environment, it is important that the core of your portfolio is allocated to funds with low expense ratios.

VTWO's SEC yield is approximately 1.47%.

Conclusion

I believe VTWO is a good ETF for the small-cap portion of an investor's Core ETF portfolio. IJR, VB and SCHA are also good choices and may be used to rotate into for the small-cap portion of an investor's core portfolio, when tax loss selling. Although the U.S. small-cap market has recently sold off, I do not believe it is cheap versus either historical valuations or U.S. large-cap or mid-cap stocks. Dollar cost averaging a new investment into VTWO is probably a good idea. After reviewing the other ETFs in the core ETF portfolio, I expect to allocate a portion of my portfolio, currently allocated to individual stocks, to either VTWO, IJR, VB or SCHA.

Addendum

Seeking Alpha's Investment Guide Core ETF Portfolio

ETF Ticker

Fund Name

Fund Description

Expense Ratio

VOO

Vanguard S&P 500 ETF

Large cap U.S. stocks

0.05%

IJH

iShares Core S&P Mid Cap ETF

Mid cap U.S. stocks

0.12%

VTWO

Vanguard Russell 2000 ETF

Small cap U.S. stocks

0.15%

IEFA

iShares Core MSCI EAFE ETF

Multi cap foreign developed market stocks

0.12%

IEMG

iShares Core MSCI Emerging Markets ETF

Multi cap emerging market stocks

0.18%

LQD

iShares iBoxx $ Investment Grade Corporate Bond ETF

US investment grade corporate bonds

0.15%

PLW

PowerShares 1-30 Laddered Treasury Portfolio ETF

US Treasuries

0.25%

SCHP

Schwab U.S. TIPS ETF

US TIPS

0.07%

VNQ

Vanguard REIT Index ETF

US REITs

0.10%

DBC

PowerShares DB Commodity Index Tracking ETF

Broad commodities

0.85%

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Simply Investing - Philosophy

Establishing a core portfolio in well-diversified, low expense ETFs, held for the long term, is a good idea for most all investors. The core of a small portfolio can start off as simple as one well diversified global ETF with a low expense ratio, like the Vanguard Total World Stock ETF (NYSEARCA:VT). Typically, as the portfolio grows, the core of the portfolio would include exposure to the ten asset classes listed above.

There are four steps needed to set up an efficient investment plan. The decisions and actions required to set up the plan and purchase the ETFs can be done in about four hours (see the further reading section below for more details):

  1. Decide on an asset allocation plan among the ETFs in the core portfolio.
  2. Open an online brokerage account with a linked online bank account.
  3. Determine if you will invest all your investment funds at once or over a period of time.
  4. Determine which investments to buy in your taxable and tax deferred accounts.

The core ETF portfolio outlined above, after tax, should significantly outperform either individual stock picking or a portfolio managed by a financial advisor. Over the typical investors time horizon of 40+ years the expected advantage of this core ETF portfolio is staggering.

Investors that enjoy the investment analysis process and are willing to spend the time to analyze and invest in individual stocks or sectors can still do this. I believe, the majority of these investors should still set up a core ETF portfolio, but can allocate a small, fixed percentage of their portfolio to "edge" positions, which offer additional risk and opportunity.

Further reading

ETF Investing Guide - Written by Seeking Alpha's Founder in 2006 is a great guide for setting up a portfolio of ETFs.

Set Up A Core ETF Portfolio Now - Describes the four steps required to implement the suggestions in the ETF Investing Guide. The ETF Investing Guide is made up of 54 articles and takes some time to read and assimilate the information. This article condenses the information from the guide down to four steps that can be completed to set up a core ETF portfolio in around four hours.

VOO the first ETF in the core ETF portfolio is reviewed here, The First ETF You Should Buy.

IJH the second ETF in the core ETF portfolio is reviewed here, IJH: The Second ETF You Should Buy

This article reviewed VTWO the third ETF in the core ETF portfolio.

Future articles will review the rest of the ETFs in the core ETF portfolio.

Disclosure: I am/we are long VT.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.