Investing in U.S. Small Cap Value ETFs

Factor investing & small-cap value

Back in the 1990s, Eugene Fama and Kenneth French identified a set of three (later expanded to five) risk factors that drove investment returns. Today, the list includes market, size, value, profitability, and investment. You may recognize some of these factors from various "smart beta" ETFs out there, which are funds that attempt to target different ones.

We'll be focusing on the size and value factors, which are defined as follows:

• Size: Returns of small-cap stocks minus the returns of large-cap stocks (Small minus Big, or SmB).
• Value: Returns of high-book-value stocks minus the returns of low-book-value stocks (High minus Low, or HmL).

Small-cap stocks have market capitalizations below $2 billion, while value stocks are those that appear to be trading at prices below their fundamentals (mainly price-to-equity, price-to-sales, and price-to-book ratios). These are some basic criteria, and funds out there may have more stringent screens. 

Combining the two factors creates small-cap value stocks, which have historically been the strongest performing component of the U.S. market by a long shot. In line with what we discussed earlier, they tend to be riskier, and investors have historically been rewarded with higher returns for taking that on. 

That being said, there have been periods of time, however, where the small-cap value premium returns negative. That is, large-cap growth stocks beat them, like in the previous decade, thanks to FAANG stocks. This is to be expected. Even the market risk premium has returned negative at times, with risk-free T-Bills beating stocks. A small-cap value tilt requires a long time horizon and conviction to pay off. 

Small-cap value ETFs

Selecting a small-cap value fund isn’t as easy as just looking at the name of the ETF. Many funds purport to target small-cap value but actually hold mid-caps or non-value stocks. A better way is to conduct a factor regression analysis, which can be done via Portfolio Visualizer. Investors can use factor regression for backtesting various funds and comparing their "loadings" for the size and value factors. 

In my opinion, the best small-cap value ETFs on the market come from two fund managers with a strong history of factor investing expertise: Dimensional Fund Advisors and Avantis Investors. Some examples of their ETFs include:

• Dimensional U.S. Small Cap Value ETF (DFSV): 0.33% expense ratio
• Avantis U.S. Small Cap Value ETF (AVUV): 0.25% expense ratio

Both ETFs use systemic screening methodologies and rigorous frameworks to sift out small-cap stocks that truly trade-in value territory. For a more passive, lower-cost approach, investors can also use more traditional index ETFs, but keep in mind that for factor investing, these funds might have lower loadings:

• SPDR S&P 600 Small Cap Value ETF (SLYV): 0.15% expense ratio
• Vanguard Small-Cap Value ETF (VBR): 0.07% expense ratio