By Dr. Jim Dahle, WCI Founder
Many stock mutual fund investors are “factor investors.” That means they tilt their portfolio toward stocks with certain factors in hopes of achieving higher risk-adjusted returns going forward. The idea is to diversify between different factors or risks rather than just between sectors and different stocks. I have discussed this many times and encouraged those who choose to tilt their portfolios to stay the course even when it seems their tilt is out of favor.
Most recently, I published a post in May 2020 (written earlier) encouraging people to stay the course with their small value tilt—the most common factor tilt—even though it appeared to “not be working” at the time. From the bottom of the market in March 2020 through the rest of 2020, small value outperformed the overall market 85% to 70%. Small value beat the overall market 28.09% to 25.71% in 2021 and -9.36% to -19.51% in 2022 (but it did underperform through the first half of 2023).
The purpose of today's post is not to debate whether you should tilt your portfolio to small and value. If you want to read more about that, try these posts:
- What About Value Investing?
- Understand What You Own
- Larry Swedroe's Factor Investing Book
- Rick Ferri vs. Paul Merriman on Factor Investing
- Evidence-Based Investing with Larry Swedroe
Instead, we're going to talk about what vehicle you should use if you choose to tilt your portfolio to small and value. This post was originally written in 2021. However, I have now updated it using data through July 2023. The main reason for the update was to include two actively managed small value ETFs from factor investing guru Dimensional Fund Advisors (DFA) and from Avantis, a subdivision of American Century founded by a bunch of DFA people who seemed most upset that DFA would not do ETFs. Well, once Avantis launched its ETF, DFA followed suit. Now, there are small value ETFs available from both of them. These ETFs are technically actively managed, but if you talk to DFA, this is what it'll tell you about active management.
DFA claims (as does Avantis) that its philosophy is still passive, even if its implementation of that philosophy is active. DFA sees that as very different from a typical actively managed mutual fund or ETF. Since DFA and Avantis understand that the most important aspect of passive investing is keeping costs down, many informed investors do consider their funds/ETFs, particularly when looking for a small value tilt. So, we'll include them in this analysis and my recommendations.
What Small Value ETF Funds I Have Used
My records show that the first time I bought a share of a small value fund was in July 2007. I've been a big fan of Vanguard since I became financially literate more than 15 years ago, so I've always used the Vanguard Small Value Index Fund (VSIAX for the traditional mutual fund; VBR for the ETF version) for this tilt. I've always been aware it was neither the smallest nor the most value-y of small value funds. But the cost was very low (currently an expense ratio of 0.07%), and it was well-diversified. It served my purposes. If I wanted more tilt to the portfolio, I could just add more of it. The big debate back then was whether it was worth paying an investment advisor to get access to the DFA small value fund, which was smaller and more value-y. I wrote about that in 2013 and, in fact, I have actually used both Vanguard and DFA small value funds in my childrens' 529s for more than a decade:
- DFA vs Vanguard
Now, more and more investors are using ETFs rather than mutual funds. Aside from the unique Vanguard Fund/ETF structure (the patent for which recently expired), ETFs are a little more tax-efficient than traditional funds, and they can be purchased at any brokerage for minimal cost. Since we have money spread across Schwab, Fidelity, and Vanguard brokerages (not necessarily by choice), using ETFs allows us to use the same fund in each place. The explosion of ETFs has created numerous additional options for small value investors, so I thought it was time to take a look at my fund choice again. As a reminder, our overall portfolio asset allocation looks like this:
Stocks/Bonds/Real Estate: 60/20/20
- US Total Stock Market: 25%
- US Small Value: 15%
- Total International Stock Market: 15%
- International Small: 5% (although maybe soon to finally be international small value; stay tuned)
- TIPS: 10%
- Nominal Bonds: 10%
- US REITs: 5%
- Equity Real Estate: 10%
- Debt Real Estate: 5%
Since small value makes up as much of the portfolio as all of my private real estate holdings, it seems worthwhile to spend some time on this decision. Plus, as our taxable to tax-protected account ratio rapidly grows, we're now having to move small value stocks into our taxable account (along with TSM, TISM, IS, nominal bonds, and real estate). We now need tax-loss harvesting partners, i.e. ETFs, that we're just as comfortable holding long-term as our original choice. Is VBR (and our chosen tax-loss harvesting partner VIOV) really still the best choice for us?
Small Cap Value ETF Options
Let's go through each of the reasonable options one by one and discuss their various merits. We'll start with this overview chart comparing small value ETFs (you can click on the image below to make it larger). Note that I am only looking at ETFs, not traditional mutual funds. If you are willing to look at funds too, be sure to look at the DFA and Fidelity options in addition to these 10 ETFs.
#1 VBR
Unlike the other options on this list, the Vanguard Small Value Index Fund is available as a traditional mutual fund (VSIAX, started in 1998) or as an ETF (VBR, started in 2004). It boasts a very low expense ratio at just seven basis points. That's not quite free, but it is very close. As you can see, it is not a 100% small value fund. None of these ETFs are, but this one is less so than any of the others. There is a fair amount of mid-caps and “blend” stocks. In fact, this is what draws most of its criticism—it isn't small or value-y enough for some people's taste. Personally, I appreciate its low costs and liquidity and Vanguard's demonstrated ability to closely track an index over long periods of time.
#2 VIOV
Unlike its mutual fund lineup, the Vanguard ETF lineup includes three small value index funds. The Vanguard S&P Small-Cap 600 Value ETF (VIOV), founded in 2010, is not as old as VBR (2004), but it has become a worthy alternative. It is significantly smaller than VBR and slightly more value-y. It only has half as many stocks, so it is less diversified. It is also dramatically less liquid. Even Vanguard tries to steer you away from this ETF and in to VBR:
VIOV is what we have used in our taxable account as a tax-loss harvesting partner for VBR.
#3 VTWV
The third small value ETF in the Vanguard lineup was started at the same time as VIOV (2010), but it follows a different index—the Russell 2000 Value Index. This fund offers more diversification than either of the above funds with 1,434 stocks, but that's about the last good thing I can say about it. It is about as small as VIOV but slightly less value-y. It has about the same liquidity, it costs about the same, and it has just as much trouble tracking its index closely. However, despite a very similar makeup, its performance over the last 10 years is dramatically worse, over 1.7% (per year) worse than VIOV and VBR. I don't know what it is about Russell indexes, but the performance of index funds that track them never is very impressive to me.
#4 IJS
Moving from Vanguard over to Blackrock's iShares, we come to the iShares S&P Small-Cap 600 Value ETF. This tracks the same index as VIOV above, but it charges a little more and seems to have more trouble tracking its index. As you would expect, it has a similar performance to VIOV.
This ETF was formed in 2000 and, thus, is one of the granddaddies among small value ETFs. The major benefit of IJS over VIOV is simply liquidity, but I'm not sure I'd give that up in exchange for such difficulty tracking its index and slightly lower performance. This indexing stuff doesn't seem to be that hard, but this particular ETF sure seems to struggle with it.
#5 IWN
This second offering from iShares follows the Russell 2000 Value Index, similar to VTWV. It has great liquidity (it is the most liquid of these 10 ETFs), and it does a better job tracking its index than IJS does. Maybe the problem is its index. Like IJS, this ETF was formed in 2000. Despite its massive liquidity, it is still significantly more expensive than its Vanguard counterparts with an expense ratio of 0.24%. In fact, given the higher ER, it is impressive that its long-term tracking error is so similar.
#6 SVAL
This is a relatively new ETF (also from Blackrock) without a very long track record. It is one of the least diverse of the small value ETFs with just 232 holdings. That is by design, as it tracks an index that has few holdings. The Russell 2000 Focused Value Select Index is supposed to be an improvement on all of the above indexes. It is slightly smaller and significantly more value-y. Its one-year return of 1.82% is significantly lower than that of any other ETFs in this analysis. Basically, it's a disaster.
The ETF is a little bit DFA-like—passive but with rules that are supposed to beat traditional indexing techniques. I'm a little skeptical. Given its very short (and bad) track record and the fact that it trusts Russell to make a decent index, I think I'll hold off on this choice for a few years. Interestingly, it's already twice as liquid as two of the three Vanguard ETFs.
#7 SLYV
This is SPDR's answer to VIOV and IJS. Actually, it's been around just as long as IJS and a decade longer than VIOV. It is cheaper and almost as liquid as IJS, but it shares the same trouble tracking its index (although it seems to be doing better with this more recently). Interestingly, it has slightly higher returns than VIOV despite higher expenses.
#8 RZV
Here is a fairly unique ETF, designed for those who think that even the S&P SmallCap 600 Value and the Russell 2000 Value indexes aren't value-y enough for their taste. The Invesco S&P SmallCap 600 Pure Value ETF follows its namesake index—the S&P SmallCap 600 Pure Value index—and as you can see, it is even more value-y.
If you want small value, this is small value. But look what you have to give up to get it. You have to give up diversification (only 139 stocks compared to 450-1,450 in the other ETFs), you have to give up additional expenses (0.35% vs. 0.07%-0.20%), and you have to give up liquidity (it's the least liquid of the ETFs). And you still have significant tracking errors. Some years, that tracking error is pretty small, but in other years, it is as high as 0.79%.
#9 DFSV
It's technically a nearly new ETF, but one can look to the DFA small value traditional mutual fund for a track record (and we have for the five-, 10-, and 15-year figures in the chart). It's exciting to get a DFA product without having to hire a 1% AUM advisor to do so. While smaller and more value-y than the flagship Vanguard VBR, it is not as value-y as SVAL or RZV. It is also one of the most expensive of the ETFs in this analysis at 0.31% (although that sure beats 1.31%). Why do people get excited about DFA? In short, it's the performance. While VBR tends to outperform the DFA small value offerings when small value is out of favor, vice versa is also true. Thirteen percent vs. 8.5% over the last year is a big difference, and even if you look back to the 10-15 year data (remember that for most of those 15 years, small value has been out of favor), you can see that the DFA small value offerings really didn't do much worse than VBR. There is definitely manager risk involved when you step out of a completely passive offering, but it's easy to see why lots of people go with DFA for a small value tilt.
#10 AVUV
This one has actually been around a little longer than DFSV, but it can be compared pretty easily to it. Avantis is composed primarily of ex-DFA staff, so you should expect similar methods to be used. Looking at the chart above, you can see that the Avantis fund is smaller but slightly less value-y, a little cheaper, and a little less diversified than the DFA offering. The Avantis ETF is slightly more liquid, but both of these are far more liquid than RZV. In fact, their liquidity is similar to or even better than VBR. You should be aware that Avantis and DFA are not JUST using the small and value factors in these ETFs. They are also using the “profitability” factor, which introduces a confounding variable when compared to their more passive brethren. DFA used to use the “momentum” factor a lot, but it seems to be shying away from that these days (possibly due to the difficulty in capturing it in actual practice). I get a little worried when a fund is jumping from factor to factor. Avantis just hasn't been around long enough to know if it's going to use that. But Avantis is very transparent about the fact that this is an actively managed ETF, so that's a risk.
How to Choose an ETF
When choosing an index fund to represent an asset class in your portfolio, there are really only two questions that you need to answer.
#1 Which Index?
This decision is really looking at the fund's investments. When it comes to styles or factors, this matters a lot more than with total market index funds. The methodology of deciding what a small company is and what a value company is affects performance.
#2 How Well Does the Fund (or ETF) Track It?
It turns out there is some skill required to track an index, and some people and companies are better at it than others. The price definitely matters, but it should be built in to the tracking error. Most funds lend securities to short sellers, and this has the potential to make up for a significant portion of a fund's expense. But only some companies (like Vanguard and Fidelity) pass all of the income from those activities back to the shareholders. iShares only passes back 75%-82% of that income to shareholders. Invesco passes back 90%.
When looking at these 10 ETFs, they can really be broken down into six groups based on the index they track.
- CRSP Small Value Index (VBR)
- S&P SmallCap 600 Value (VIOV, IJS, SLYV)
- S&P SmallCap 600 Pure Value (RZV)
- Russell 2000 Value (VTWV, IWN)
- Russell 2000 Focused Value Select Index (SVAL)
- No index (DFSV, AVUV)
As you would expect, the Russell 2000 tracking ETFs have almost the exact same 10-year returns. That makes what has happened with the S&P SmallCap 600 Value tracking ETFs 5-15 years ago all that much more bizarre. Take a look at this chart that was put together just before the market began to crater at the beginning of 2022:
I mean, what in the world? The only good news there is that it seems they're all getting better at doing this indexing thing in the last five years.
I find the S&P 600 Index to be intriguing and attractive. Given how large growth has outperformed small value over the last decade, I would have expected these ETFs to have underperformed VBR over that time period—like the Russell 2000 Value tracking ETFs and, most impressively, RZV. But they didn't, despite being smaller and more value-y.
I was curious to see how SVAL did in its first few years, but what I'm seeing so far is not very impressive.
Best Small Cap Value ETF
Your good options here are three-fold:
#1 The Case for VBR
I still think VBR is a great choice. It is liquid, diverse, and very low cost, and it tracks its index well. The only beef anyone has with it is that it isn't as small and value-y as the other ETFs. An easy solution is to simply hold more of it. If you wanted 10% of your portfolio in something like RZV or VIOV, then just put 12% or 15% into VBR and call it good.
#2 An S&P SmallCap 600 Value Tracking ETF
If VBR isn't good enough for you, these three ETFs offer a solid option at a reasonable cost. If minimal tracking error matters most to you, then go with VIOV. If liquidity matters more, then go with IJS or SLYV. Either way, any of these three ETFs make for excellent tax loss-harvesting partners for VBR or each other. Are they substantially different from each other to use as tax-loss harvesting partners? Well, the IRS has a strong argument that they're substantially identical since they all follow the same index. But let's be honest: the CUSIP is different, so nobody really cares. I still have yet to meet someone who was audited on this particular point. VIOV is an obvious tax-loss harvesting partner for people with a primary holding of VBR.
#3 An Actively Managed ETF (or the Pair of Them)
In the last version, RZV was the third reasonable option for the purists looking for the smallest and most value-y fund. It has serious liquidity and diversification issues, though. If you really want something smaller and more value-y than VBR or VIOV, your best bet is probably the actively managed ETFs. You're taking on manager risk and higher expenses, but if you believe in the DFA (and now Avantis) methodology (i.e. passive philosophy with active implementation), this is probably the way to go. DFA wins the one-year performance battle, but Avantis wins the three-year performance. What the future holds is anybody's guess, but I lean slightly more toward Avantis. I've never liked DFA's advisor-centered approach, and without the Avantis folks breaking off, I suspect DFA would still be doing that. And it's nice to have a little bit lower ER. DFA does have a lower turnover, however, which may indicate it could be more tax-efficient. If you're investing mostly in a taxable account anyway, you probably need two of these funds so DFSV would make a great tax-loss harvesting partner for AVUV.
What Are the Dahles Going to Do Now (as of Summer 2023)?
After discussion, we decided that we're impressed enough with AVUV and DFSV to change from VBR and VIOV to AVUV and DFSV. However, we're not going to realize a bunch of capital gains to do so. Right now, we have our small value holding spread across numerous accounts—including my practice Roth 401(k) at Schwab, Katie's Roth IRA, and the big taxable account in our trust. About 80% of it is in taxable, two-thirds in two lots of VIOV (both with significant gains) and one-third in five lots of VBR (all with significant gains).
We could swap the 20% of our small value for AVUV with no tax consequences, but as far as those taxable holdings go, we're only going to be putting new money toward AVUV +/- DFSV. We might slowly trim those appreciated shares using our charitable donations each year, but we've got a whole lot more in appreciated taxable small value shares (VBR and VIOV) than we typically give to charity—even over a couple of years—so we may be “stuck” with them for quite a while. Especially since the gains in five of the seven lots are still short-term!
There are now lots of great options for low-cost, passive, or mostly passive small value ETFs. It is exciting to see the DFA and Avantis ETFs now available to investors and performing well. Small value tilters are faced with difficult choices in this asset class.
What do you think? Do you use a small value ETF? Which one and why? If you had to tax-loss harvest, which one would you go to? Comment below!
[This updated post was originally published in 2022.]
