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):

 

  • Vanguard's VISVX had a beta loading of 0.94, while DFA's DFSVX's loading on beta was 1.0. We should expect both to have betas of close to one, with DFSVX's slightly higher loading being explained by its owning smaller stocks, which tend to have higher betas. The slightly higher beta should contribute to higher returns, as beta's annual premium was 5.4 percent.
  • Given the Morningstar data we examined, it shouldn't be a surprise that VISVX had a lower size-loading than did DFSVX—0.58 versus 0.82. The higher size-loading for DFSVX should contribute to higher returns, as the size premium was 5.4 percent.
  • DFSVX also had a somewhat higher value loading, 0.65 versus 0.62 for VISVX. The slightly higher value-loading should make a small contribution to returns, as the value premium was 3.9 percent.
  • It's typical that value funds will have negative loadings on the momentum premium. And that's the case here, as both funds had slightly negative loadings—DFSVX (-0.07) and VISVX (-0.10). The small negative loadings subtracted from both of their returns—a bit more from VISVX, in fact—as the momentum premium was 4.1 percent.
  • The r-squareds were very high in both cases—0.93 for VISVX and 0.96 for DFSVX. That tells us that the model is doing a very good job of explaining the variability in the returns of the two funds.

As you should expect of a pure index fund, VISVX's alpha was slightly negative, at -0.01 percent per month, a bit less than its expense ratio of 0.22 percent. DFSVX's alpha was slightly positive, at 0.04 per month—and to generate its alpha, it had to overcome a higher expense ratio—0.52 percent.

The alpha might have been generated from the various screens DFA employs, or from its patient trading strategy. Or it might be a result of the fact that the value premium is actually largest in the smallest stocks, which DFSVX owns more of. Whatever the source, DFA's fund construction and implementation strategies added to returns beyond just the contribution from the higher loading factors.

Before moving on, it's important to note that some of the alpha is related to the greater securities-lending revenue DFSVX generates, which is mainly due to the fact that the smaller stocks it owns tend to command greater fees when they are lent out.

Summary

Relative to VISVX, in each case, DFSVX's returns benefited from its different factor loadings: The higher beta-loading contributed 0.32 percent to its returns (5.4 percent x .06); the higher size-loading contributed 1.30 percent (5.4 percent x .24); the higher value-loading contributed 0.12 percent (3.9 percent x 0.3); and the less negative momentum-loading contributed 0.12 percent (4.1 percent x 0.03).

The total relative benefit from the loadings on the four factors was 1.86 percent. The benefits of the higher loadings, along with the contribution from the alpha the fund generated, explain the difference in returns between the two funds.

Even though the two funds are both small-cap value funds, and both are "passively" managed, over the period 1999-2013, DFSVX returned 12.28 percent per annum, while VISVX returned 10.03 percent per annum. It's also important to note that, as you would expect from a fund owning much smaller and deeper value stocks, DFSVX experienced greater volatility—its annual standard deviation was 24.1 percent versus 19.7 percent for VISVX.

However, the higher returns more than compensated for the higher volatility, as the Sharpe ratio for DFSVX was 0.53 versus 0.49 for VISVX.

Until now, we've only looked at how the funds performed in isolation. However, as Harry Markowitz demonstrated, the right way to consider any investment is to consider how its addition impacts the risks and returns of the overall portfolio. Thus, we'll now turn our attention to how the addition of these two funds would have impacted the performance of a balanced portfolio.

Our base case is Portfolio A. Its holdings are 60 percent S&P 500/40 percent 5-year Treasury notes. Portfolio B keeps the same 60/40 allocation, but splits the equity portion equally: 30 percent S&P 500 and 30 percent DFSVX. Portfolio C splits the equity portion equally between the S&P 500 and VISVX. Portfolio D lowers the equity allocation to 50 percent, splitting it 30 percent S&P 500 and 20 percent DFSVX, while increasing the bond allocation to 50 percent 5-Year Treasury Notes.

 

1999-2013

Annualized
Return (%)
Standard
Deviation (%)
Worst
Year (%)
Sharpe
Ratio
Portfolio A 5.6 10.0 -17.0 0.39
Portfolio B 8.0 10.8 -16.9 0.59
Portfolio C 7.2 9.6 -15.5 0.57
Portfolio D 7.3 8.1 -11.9 0.67

 

As you can see, the addition of either of the two small value funds improved both the returns and the risk-adjusted returns (Sharpe ratio) of our starting portfolio.

Portfolio B, using DFSVX, produced higher returns (8.0 percent versus 7.2 percent) than Portfolio C using VISVX. But it also experienced higher volatility (10.8 percent versus 9.6 percent), and it also experienced a greater worst-case loss (16.9 percent versus 15.5 percent).

Portfolio B delivered a slightly higher Sharpe ratio than Portfolio C (0.59 versus 0.57).

The most efficient portfolio of them all, however, was Portfolio D, which held the least amount of equity. Despite having an equity allocation of just 50 percent, it produced a higher return than either Portfolio A or C, and it did so with lower volatility than either.

It also experienced a much lower worse-case loss. Portfolio D's Sharpe ratio was 0.67 percent—72 percent higher than Portfolio A's Sharpe ratio, 21 percent higher than Portfolio C's Sharpe ratio, and 17 percent higher than Portfolio B's Sharpe ratio.

This example demonstrates that there are two ways an investor can benefit from adding exposure to factors such as size and value to their portfolios. You can use the higher expected returns and non-perfect correlations to increase expected returns without proportionally increasing risk, because of the diversification benefits. This is the way most investors have been shown to use the factor exposures.

Alternatively, you can use those higher expected returns and diversification benefits to lower the amount of equity needed in the portfolio to achieve the same expected return.

This second alternative is the strategy discussed in detail in a new book co-authored with my colleague Kevin Grogan, "Reducing the Risk of Black Swans: Using the Science of Investing to Capture Returns With Less Volatility." We believe this is an especially effective strategy for risk-averse investors—investors who have a relatively low marginal utility of wealth and are thus more concerned about wealth preservation than they are about wealth accumulation.

Bottom Line

The bottom line is that even two "passively managed" funds in the same asset class can produce very different returns and different risks. It's important that each investor choose the fund that best meets his or her individual objectives.

That said, the greater the exposure of a fund to the factors of size and value (the smaller the market capitalization and the lower the prices to book value, earnings and cash flow), the less equity risk the investor will need to meet their objective, and the less tail risk there will be; that is, the smaller the worst-case drawn down will be.

An additional benefit of the strategy is that the lower equity allocation allows you to hold more safe bonds, and the costs of implementing the bond allocation are lower than they are for the equity portion. In fact, if you limit your holdings to Treasurys, government agencies, FDIC-insured CDs and AAA/AA-rated municipal bonds that are also general obligation bonds and essential services bonds (as we recommend), then you can build your own portfolio, eliminating the costs of a mutual fund, though you would lose some of the convenience benefits a fund offers.

In the end, passive investors today have many good options, beyond DFA and Vanguard, for investing in small value funds. Among them are Bridgeway funds and ETFs from Guggenheim, iShares, Stage Street Global Advisors and Wisdom Tree.


Larry Swedroe is a director of Research for the BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.

 

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