Swedroe: Understanding Small Value ETFs

When it comes to isolating the small-value factor, sometimes a higher expense ratio is justifiable.

As a continuation of our previous discussion earlier this month on small value mutual funds, today I'd like to review the metrics of some popular small value ETFs. As a reminder, the smaller and more "valuey" the stocks that a fund owns, the higher the expected returns of the portfolio are.

The following table, with data from Morningstar as of June 30, 2014, shows various metrics for the seven small value ETFs with at least $100 million in assets under management.The list includes three ETFs from iShares, as well as funds from Guggenheim, SPDR, Vanguard and WisdomTree.

The table shows weighted average market capitalization to demonstrate each fund's relative exposure to the size premium in addition to four different value metrics (price-to-earnings, price-to-book, price-to-sales and price-to-cash flow) to demonstrate each fund's relative exposure to the premium provided by value stocks.

Of these seven funds, the largest by market capitalization are the Vanguard Small Cap Value ETF (VBR | A-100) and the iShares Morningstar Small-Cap Value ETF (JKL | A-86). The smallest fund is the Guggenheim S&P SmallCap 600 Pure Value ETF (RZV | B-52). All else being equal, the smaller the market cap of a fund, the greater its expected return.

We should also expect to see that, when small stocks outperform large stocks, the iShares Morningstar fund and the Vanguard fund should underperform the other ETFs. This doesn't mean the iShares Morningstar and Vanguard funds are "bad" or poorly run, it just means they have less exposure to the size premium. In turn, we should expect that these funds will outperform when large stocks outperform small stocks.

In terms of the four value metrics, the iShares Morningstar Small Value ETF and the Guggenheim S&P SmallCap 600 Pure Value ETF stand out as having a relatively low price. By comparison, the other five ETFs have similar value metrics. As a result and, again, all else being equal, we should expect that when value stocks outperform growth stocks, the iShares Morningstar Small Value and Guggenheim S&P SmallCap 600 Pure Value funds will outperform the other five ETFs.

When deciding which ETF to use, investors should pay attention to the size and value metrics, as well as the expense ratio. Too many investors fixate on the expense ratio and mistakenly assume that it's the only thing that matters.

Certainly, expenses play an important role in determining future returns, but paying a little bit more by way of a higher expense ratio can be well worth it if your goal is to seek exposure to the size and value premiums.

Larry Swedroe is director of research for The BAM Alliance, a community of more than 140 independent registered investment advisor firms throughout the country.