ETF Trends
ETF Trends

Small-caps have hit their stride in 2015 with the Russell 2000 and the S&P SmallCap 600 up an average of 5.5% for the year.

Investors are responding, having plowed a combined $1.8 billion into the iShares Core S&P Small-Cap ETF (NYSEArca: IJR) and the Vanguard Small Cap ETF (NYSEArca: VB) since the start of the year. Exchange funds offer investors the opportunity to further parse the small-cap universe while emphasizing the growth or value segments of the small-cap space. The Vanguard Small-Cap Value ETF (NYSEArca: VBR) is one avenue for gaining exposure to small-cap value names.

“Small-cap value stocks have historically represented the best-performing segment of the U.S. equity market,” said Morningstar analyst Alex Bryan in a recent research note. “VBR invests in the cheaper half of the U.S. small-cap market and weights its holdings by market capitalization. Market-cap-weighting incorporates market information about the relative value of each holding and helps mitigate turnover. However, it may also reduce the fund’s exposure to holdings as they become cheaper because this often coincides with a decline in market capitalization.”

Like many of its Vanguard ETF brethren, VBR has become a prolific asset gatherer due in part to its scant expense ratio. Home to $5.2 billion in assets under management, VBR charges just 0.09% per year, or less than 93% of rival funds, according to Vanguard data.

VBR tries to reflect the performance of the CRSP US Small-Cap Value Index, which is comprised of small-cap stocks that represent the 85th to 95th largest percentile of the U.S. stock market. The underlying CRSP index employs specific  value and growth scores to each stock before selecting component holdings. The value factors include book-to-price, earnings-to-price, sales-to-price and dividends. [Value in a Small-Cap ETF]

Although VBR proffers a value tilt, it is not a bargain with a P/E ratio of 21.6. However, the ETF is lightly allocated to the health care and technology sectors, homes to some of the most richly valued small-caps. Those sectors combine for just 13.4% of VBR’s weight.

“Low valuations do not necessarily make a stock a bargain. A company’s fair value is the present value of its future cash flows, plus the value of its financial assets, minus debt. Earnings growth is an important part of that equation. An investor should be willing to pay more for a company with higher expected growth,” according to Morningstar.

In the current environment of dollar strength, small-caps have their advantages. For instance, most smaller companies are not exposed to foreign exchange risks and the strengthening dollar. According to Bank of America Merrill Lynch, 81.3% of revenue from the Russell 2000 Index is generated within the U.S., whereas 64.3% of revenue for S&P 500 companies come from the states. [Small-Caps Look Pricey]

VBR is up about 5% year-to-date.

Vanguard Small-Cap Value ETF

Tom Lydon’s clients own shares of IWM.