4 ETFs to Consider From an Undervalued Part of the Market

Key Concepts

• Small Cap ETFs: Exchange-Traded Funds that invest in companies with small market capitalizations.
• Diversification: Spreading investments across various assets to reduce risk.
• Index Funds: ETFs that passively track a specific market index.
• Active ETFs: ETFs where a portfolio manager actively makes investment decisions.
• Market Beta: The systematic risk of an investment that cannot be diversified away.
• Value Investing: An investment strategy that involves buying securities that appear underpriced based on fundamental analysis.
• Profitability: The ability of a company to generate earnings.
• Outflows: When investors withdraw money from an ETF or fund.
• Contrarian Investing: An investment strategy that goes against prevailing market trends.
• Style Box: A tool used to categorize stocks based on market capitalization (size) and investment style (growth vs. value).
• Price to Fair Value: A valuation metric comparing a stock's market price to its estimated intrinsic value.
• Basis Points (bps): One-hundredth of a percentage point (0.01%).

Small Cap ETFs vs. Individual Small Cap Stocks

Brian Armor, Morningstar's Director of ETF and Passive Strategies Research for North America, argues that for individual stock investors, considering small cap ETFs over buying individual small cap stocks outright offers significant advantages, primarily through diversification. The core argument is that most small cap stocks will not outperform in the long term. By holding hundreds or even thousands of small cap stocks within an ETF, investors gain exposure to the eventual winners without the need to precisely pick them. This approach shifts the focus from identifying exact winners to ensuring exposure to the segment of the market that contains those winners.

Key Considerations When Researching Small Cap ETFs

When investors are researching small cap ETFs, several key factors are crucial:

• Cost: This is paramount and manifests in two ways:
  • Fees: Investors should optimize for lower fees for comparable strategies.
  • Trading Costs: Small cap stocks, especially micro-caps, are more expensive to trade. Index funds in this space can involve significant trading. Therefore, ETFs with limitations on trading activity are preferable to avoid accumulating substantial trading costs for minimal economic benefit.
• Index Understanding: Investors must understand the specific index an ETF is tracking.
• Portfolio Holdings: A close examination of the ETF's portfolio is essential. Two small cap ETFs can have vastly different sector exposures or occupy different positions within the style box, even if they track small cap indexes.

Passive vs. Active Small Cap ETFs

The discussion delves into the debate between passive index funds and active ETFs in the small cap universe.

• Passive Index Funds: Brian Armor notes that success rates are generally higher for passive strategies compared to active ones, particularly in the small cap US stock market.
• Active ETFs: While newer, active ETFs have found a niche in the small cap space. However, a challenge for concentrated active strategies in an ETF wrapper is that ETFs cannot close to new investors, unlike mutual funds. This can lead to issues with managing inflows and outflows.
  • Popular Active Strategies: Active ETFs in the small cap space tend to be broader portfolios with systematic selection and tweaking. Examples include strategies from Dimensional Fund Advisors and Avantis.
  • Recommendation: Armor suggests that index funds or broad portfolio active ETFs are generally advisable. These approaches mitigate concerns about concentration risk and the impact of fund flows.

Index Variations in the Small Cap Space

While there isn't one definitively "better" index for small cap ETFs, there are variations in how they achieve their objectives:

• S&P 600: Tracks approximately 600 of the largest U.S. small-cap stocks that meet specific requirements.
• Russell 2000: Includes stocks ranked from 101 to 3,000 by market capitalization. A potential issue with the Russell 2000 is its lack of buffers at the lower end of the market cap spectrum.
• CRSP Indexes: These can be percentage-based, for example, tracking stocks in the 85th to 90th percentile of market capitalization.
• S&P 1500 (Composite): This index, which includes the S&P 500, MidCap 400, and SmallCap 600, has a unique requirement: companies must be profitable to be included.
• Key Features: Profitability and quality are highlighted as desirable characteristics for small cap stocks.

Interpreting ETF Outflows in the Small Cap Space

Morningstar's ETF flows data indicates that small cap ETFs have experienced significant outflows in the current year. For new investors considering small cap ETFs, this raises questions about whether outflows are a positive or negative signal.

• No Definitive Meaning: Brian Armor states that outflows don't necessarily signify anything definitive.
• Investor Sentiment Indicator: However, outflows do reveal where investors are allocating their money.
• Contrarian Opportunity: If investors are withdrawing from small caps, it could present a contrarian opportunity. The principle of "no pain, no premium" in factor investing suggests that an asset class may need to fall out of favor to have the potential for future outperformance. Therefore, current outflows might indicate a favorable time to consider investing in small caps.

Morningstar's Highly Rated Small Cap ETFs

Brian Armor highlights several small cap ETFs that Morningstar rates highly:

• Market Beta (Passive) Options:

  • Vanguard Small Cap ETF (VB): Tracks a CRSP small cap index. It is described as a broad portfolio, offering comprehensive small cap market exposure at a very low cost (5 basis points).
  • iShares Core S&P Small Cap ETF (IJR): Tracks the S&P 600 small cap index.
  • Valuation Aspect: Both VB and IJR are expected to be undervalued compared to their fair value when aggregated at the portfolio level. For investors seeking a more focused "small value" play, small value versions of these strategies are also available.

• Active Small Cap ETF Options:

  • Dimensional US Small Cap ETF (DFAS): Receives a Gold rating from Morningstar.
  • Avantis US Small Cap Equity ETF (AVSC): Receives a Silver rating from Morningstar.
  • Key Characteristics: Both DFAS and AVSC tilt towards value and profitability characteristics. They actively avoid asset growth strategies that might mask underlying cash burn and potential business failure. These ETFs are broad, holding over a thousand stocks each, and are still relatively inexpensive, with fees in the 25-30 basis point range.

Conclusion

The discussion emphasizes that small cap ETFs offer a diversified and cost-effective way for investors to gain exposure to the small cap market, mitigating the risks associated with picking individual stocks. Key considerations for selecting an ETF include costs, the specific index tracked, and the underlying portfolio composition. While passive strategies generally have higher success rates, certain broad active ETFs also present compelling options. Current outflows from small cap ETFs might signal a contrarian investment opportunity. Morningstar recommends specific passive ETFs like VB and IJR for broad market beta, and active ETFs like DFAS and AVSC for their tilts towards value and profitability.