Seven With Small-Cap Value, ETF-Style

"The Only Equity ETF You'll Ever Need!"

How's that for a headline you might read on the cover of a monthly magazine?

From all the emails I receive, I know that the range of RealMoney and TheStreet.com readers includes investors who want to make full-time jobs out of managing their portfolios with 100 holdings (not kidding) to do-it-yourselfers who want everything they need in just one exchange-traded fund (ETF).

To be clear, I don't believe either extreme is ideal for diversification, but nonetheless, there is one segment of the domestic stock market that has done better than the rest of the market over long periods of time: small-cap value.

While I could devote an entire white paper as to why small-cap value has been the best performer, that is not the focus here.

The short and sweet is that smaller companies tend to do better in the early and middle stages of a stock market cycle.

Because bull markets are more prevalent, this means that conditions favor small over large more often than not.

Similarly, a steeper yield curve (indicative of economic expansion and growth) tends to favor value companies over growth.

Again, because expansion is more prevalent than recession over long periods of time, this means value tends to do better.

By combining small-cap and value you get the best-performing market segment.

I was able to find seven small-cap value ETFs (if there aren't more than that now, there will be later), three of which are from iShares.

All seven use different indices or methodologies to capture small-cap value.


Cumulative Returns of Large-Caps vs. Small-Caps
(1928-2004)
Source: Ibbotson Associates

iShares Russell 2000 Value Index Fund ( IWN) is by far the most actively traded of the group. It has more than 1,300 holdings with the largest component weighing in at only 0.32%, so there is no single-stock threat to the index. It is very heavily weighted, 36%, to financial services, but that is misleading, as the fund counts real estate investment trusts (REITs) as part of the financial sector. Relative to this group of ETFs, IWN has a low 1.16% yield, but its return is best of the bunch.

Even though iShares S&P Small-Cap 600/Barra Value ( IJS) has less than half the holdings of IWN, the largest component makes up only 1.19% of the fund, so again, investors are protected from a single stock blowing up. The sectors are balanced more evenly as financials and industrials both account for 20% of the fund. Technology is heavier here at 15% compared with just 10% in IWN. IJS yields a similar 1.17%, but its performance has lagged IWN by several percentage points over the last year.

PowerShares Dynamic Small-Cap Value ( PWY) adds an element of active management to the equation, but the results have been poor, lagging IWN by four percentage points. It is more expensive, 0.60%, and has had a smaller yield, 0.52%. The stock-selection process is a quantitative approach that screens for companies based on fundamentals, valuations, timeliness and risk profile. While this sound good to me, the process has not given the fund any advantage as of yet.

Vanguard Small-Cap Value Vipers ( VBR) has one noticeable differentiating attribute, which is its high yield at 2.22%. Like some of the others, it is heavily tilted to the financial sector (37%) but is relatively light in the tech sector at only 8.4%. If tech turns around and provides some leadership to the market, VBR's light exposure may cause a greater lag to IWN.

iShares Morningstar Small-Value Index Fund ( JKL): I have been critical of all the Morningstar ETFs as being the poster child for the "me too" funds that have come out in the last couple of years. JKL offers a good yield (2.26%) but, according to the iShares Web site, it has zero in technology. As with VBR, when tech turns and leads again, this fund could lag badly. The process for the fund's composition is proprietary, so there is not much detail. While it is possible that tech could be added in the future (as the other funds show there are some value names in tech), owning this fund could amount to a bet that the managers will know when to add tech to the holdings.

As are many of the funds listed, streetTracks DJ Wilshire Small-Cap Value Index Fund ( DSV) is heavy in financials, has a slightly better yield than IWN and lags IWN by a few percentage points. Like most of the funds, DSV is heaviest in financials, but DSV has the highest yield of the group at 2.92%, but the extra yield does not overcome the performance lag.

Most of the funds have very little volume, and Rydex S&P Small-Cap 600 Pure Value ( RZV), the newest entrant into the space, has by far the least volume. Its performance puts it right in the middle of the pack, but it has been trading for only six months. The biggest red flag for this fund is that consumer discretionary is the largest sector at 23.7%. Discretionary stocks tend to lag during an economic slowdown or recession. If we are slowing down, RSV could lag the others.

The idea of only one product to capture the U.S. market is, as I mentioned above, not something I would suggest to anyone, but the history of this part of the market is compelling, as it is overlooked by too many investors.

Small-caps have outperformed for this entire decade, save for the last couple of months; so while it may be the wrong time to favor small-caps, ignoring the asset class entirely has been the wrong thing to do far more often than not.


Seven ETFs That Capture Small-Cap Value
Source: BigCharts.com


Please note that due to factors including low market capitalization and/or insufficient public float, we consider PowerShares Dynamic Small-Cap Value, Vanguard Small-Cap Value Vipers, iShares Morningstar Small-Value Index Fund, streetTracks DJ Wilshire Small-Cap Value and Rydex S&P Small-Cap 600 Pure Value to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

At the time of publication, Nusbaum was long IJS for a client, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, Ariz., and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.

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