Swedroe: Small Value Funds Not Equal, Part I

May 19, 2014

A close look at two small-cap value funds yields some surprises and important lessons.

Vanguard is clearly the leading provider of index fund products. Dimensional Fund Advisors is also the clear leader in its "space," managing about $350 billion in assets in what we might call structured asset class portfolios. (Full disclosure: My firm Buckingham recommends Dimensional and Bridgeway funds in constructing client portfolios.)

They are both leaders because they offer low-cost, tax-efficient versions of their products. What's important to understand is that even when they each offer a fund in the same asset class, and each fund is "passively" managed, their funds can be different in risk and expected returns. To demonstrate this point, let's look under the hood of the Vanguard Small Cap Value Index Fund (VBR | A-100) and Dimensional's Small Cap Value Fund (DFSVX).

To begin, Morningstar classifies them both as small value funds. Given the same classification, most investors would assume their holdings would look very similar. However, as you'll see, there are significant differences.

The portfolio data for each fund is from Morningstar. Unfortunately, the dates are not exactly the same, with Vanguard's data being as of March 2014, while DFA's is as of February 2014. However, the MSCI 1750 Small Value Index was up just 1.6 percent for the month, so the difference in dates shouldn't have much impact on the valuation metrics.

Fund Weighted
Average
Market
Cap
P/E P/B P/S P/CF
Vanguard Small Value (VISVX) $2.7B 16.5 1.7 0.9 7.6
DFA Small Value (DFSVX) $1.3B 16.8 1.3 0.7 5.2

 

As you can see, DFSVX has a much smaller average market capitalization—less than half that of VISVX's. And while the price/earnings multiples (P/E ratios) are similar, the price/book (P/B), price/sales (P/S) and price/cash flow (P/CF) ratios all show DFA's fund to be more "valuey."

It's important to note that this doesn't make DFSVX a better fund. In fact, if markets are efficient, we should expect to see the two funds deliver similar risk-adjusted returns. However, the fact that DFSVX's holdings are smaller and deeper value means that it has higher expected returns and, also, probably higher volatility too. Which is the better fund choice will depend on investor preferences, as well as how the addition of each fund would impact the risk and return of an overall portfolio.

With that said, we can look at how the different fund-construction rules impact the two funds in terms of exposures to the four factors that explain the vast majority of the returns of diversified portfolio; namely, beta, size, value and momentum—as well as their impact on returns and risk-adjusted returns.

To do that, my colleague and co-author Kevin Grogan ran a four-factor regression covering the 15-year period 1999-2013. Here's what he found (note: With one exception, related to the alphas of each fund, the t-stats—a ratio measuring the departure of an estimated parameter from its notional value and its standard error—were highly significant):

 

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