Swedroe: Small Value Funds Not Equal, Part II
Revisiting a common misconception.
Revisiting a common misconception.
Revisiting a common misconception.
Smart investors begin their journey by developing an investment plan, or investment policy statement, that includes an asset allocation table. After the plan has been prepared, the next step is to select proper investment vehicles for providing the appropriate exposure to the desired asset classes.
A common error among investors who follow a “passive” investment strategy is to assume that all passive funds in the same asset class are basically identical. In other words, they mistakenly believe these passive funds are “commodities,” or substitutes for one another.
If passive investment products were commodities—in the economic sense, not the physical one—the only criteria needed to make a decision when choosing among them would be cost; in this case, the fund’s expense ratio. However, as we’ll demonstrate, two funds in the same asset class can actually look very different. The differences have implications not only in terms of risk and expected returns, but in terms of how their addition impacts the risks of an overall portfolio.
We’ll demonstrate this point by comparing the metrics of two domestic small value funds, one of which has a large amount of assets under management and another with much less. Vanguard’s Small Value Fund (VISVX) has $14 billion in assets under management, while Bridgeway’s Omni Small Value Fund (BOSVX) has just $400 million in AUM.
Using data from Morningstar, the table below shows five important metrics for each of the funds. Unfortunately, Morningstar’s most recent available data for the two funds is slightly different. The data for VISVX is as of June 30; the data for BOSVX is as of March 31.
During this period, small value stocks rose about 3 percent. However, the impact this has on the following data shouldn’t be significant, though it’s likely the valuation metrics for BOSVX would be slightly higher.
VISVX | BOSVX | |
Market Capitalization | $2,869M | $662M |
P/E | 17.4 | 14.1 |
P/B | 1.8 | 1.2 |
P/S | 0.9 | 0.6 |
P/CF | 7.7 | 4.5 |
As you can see, the two funds look very different. In terms of the size factor, the average market capitalization of VISVX is more than four times that of BOSVX. This is especially important because the research demonstrates that the value premium is greater in small-cap stocks than it is in large-cap stocks.
In terms of the value factor, VISVX has a P/E ratio about 23 percent higher than BOSVX, both the P/B and P/S ratios of VISVX are 50 percent higher, and its P/CF ratio is 71 percent higher. These differences can lead to significant differences in performance.
For example, in 2013, when the size and value premiums were positive, we should have expected the smaller and more value-oriented BOSVX to outperform VISVX. That’s exactly what happened. BOSVX returned 44.6 percent and VISVX returned 36.4 percent.
Since the size and value premiums have been negative so far in 2014, we should expect that BOSVX will underperform VISVX because it has more exposure to the factors with negative returns. Through July 17, VISVX returned 5.3 percent compared with a return of 0.2 percent for BOSVX. Over the long term, we should expect BOSVX to outperform, given its larger exposure to the size and value factors.
There are a few other points of interest in this comparison. The first is that, given that BOSVX’s construction rules limit the market-capitalization buy range to that of stocks in the CRSP 7-10 Index, the largest stock it would consider purchasing would currently have a market capitalization of about $1.9 billion. The average stock in VISVX has a market capitalization about 50 percent higher than that figure.
Similarly, the highest P/B ratio BOSVX would currently consider buying—it buys equities in the highest 20 percent of stocks as ranked by their multifactor approach to value—would be about 1.35. That’s about 25 percent below the average P/B for VISVX. The other value metrics would have similar differences.
The second point is that it really would be very difficult, if not impossible, for Vanguard to effectively manage $14 billion in assets in the relatively small corner of the market to which the Bridgeway Omni Small Value fund limits its holdings. That limitation influences Vanguard’s choice of benchmark, currently the CRSP Small Value Index.
For those interested in reading more on this topic, see my post providing a detailed analysis and comparison of Vanguard’s Small Value Fund (VISVX) and Dimensional Fund Advisors Small Value Fund (DFSVX), as well as a review of how their inclusion impacted the risk and return of a diversified portfolio. (Full disclosure: My firm, Buckingham, recommends both Dimensional and Bridgeway funds in constructing client portfolios.)
Larry Swedroe is the director of research for the BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.