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Cheap Exposure to Small-Growth Stocks

This ETF's significant cost advantage should translate into attractive category-relative performance.

Alex Bryan, 07/22/2016

Vanguard Small-Cap Growth ETF VBK is one of the lowest-cost small-cap growth funds available, which gives it a sustainable edge against its peers. Its broad, market-cap-weighted portfolio effectively diversifies risk, and it applies generous buffering rules to mitigate unnecessary turnover.

This strategy targets stocks representing the half of the U.S. small-cap market with the highest growth rates and valuation ratios and weights them by market capitalization. This brings in more than 600 holdings, such as Buffalo Wild Wings BWLD, Churchill DownsCHDN, and Fitbit FIT. Small-growth firms have greater growth potential than their larger counterparts, but they also tend to be riskier. There is always a risk that the fund’s holdings may not live up to the high expectations reflected in their valuations, which could hurt performance. Most of the fund's holdings lack durable competitive advantages and exhibit greater volatility than larger stocks. Because of its volatility, this fund is most appropriate as a satellite holding for investors with a high risk tolerance.

The fund has a larger market-cap orientation than its closest peers and the small-growth Morningstar Category average. It also has much greater exposure to real estate stocks than most of its peers. While these firms may not grow as quickly as many other growth stocks, many qualified for inclusion because they have experienced high historical growth rates and currently trade at high earnings multiples.

Because it casts a wide net, this fund includes some stocks with only modest growth characteristics. However, the portfolio's growth orientation is similar to the category average. The fund has less overlap with its value counterpart (Vanguard Small-Cap Value ETF VBR) than do rival value and growth funds based on the Russell 2000 and S&P SmallCap 600 indexes. Its benchmark, the CRSP U.S. Small Cap Growth Index, applies generous buffering rules to mitigate unnecessary turnover, which should translate into lower transaction costs.

Low fees, low turnover, and broad diversification have been a winning combination. The fund outpaced its average mutual fund peer in the category by 2.4 percentage points annualized during the trailing 10 years through June 2016, with comparable volatility.

Fundamental View 
The market has high expectations for the fund’s holdings, which are reflected in their high valuation multiples and forecast growth rates. On top of their attractive growth, these stocks tend to enjoy better profitability than their value counterparts.

A company's growth must exceed the market's expectations in order to generate superior returns. That can be a tall order for the fund's holdings because investors already have high expectations for them. It may also be challenging for these companies to sustain their high growth rates. A company can grow faster than its industry only by taking market share away from its competitors. But growth encourages imitation, and rival firms may react aggressively to preserve their market share. Industry growth isn't a panacea. Fast-growing industries often attract new entrants and can experience disruptive innovation that is difficult to forecast. Growth also becomes more difficult to sustain as a firm becomes larger.

Additionally, growth is not always in investors' best interests. Manager compensation is positively correlated with firm size. Consequently, managers may be tempted to undertake risky and low-return projects to expand the business at shareholders' expense. The fund partially addresses this issue by including return on assets in its screening criteria, which penalizes companies for undisciplined growth.

There is clearly a risk that the fund's holdings may fall short of the market's expectations. The prospect of investing early in the next Starbucks SBUXTesla Motors TSLA, or Netflix NFLX is alluring. In their enthusiasm for large payoffs, investors may bid up the prices of small-growth stocks above their fair values. Even when growth stocks are fairly priced, they could lag their value counterparts if investors demand lower returns to hold these more-desirable companies.

All of this may explain why value stocks have historically outpaced their growth counterparts in nearly every market studied over the very long term. And this return gap has historically been the largest among the smallest stocks. From its inception in December 1978 through June 2016, the Russell 2000 Growth Index (which offers exposure similar to this fund's) lagged the Russell 2000 Value Index by 3.4% annualized, with greater volatility. During that span, the small-growth index also lagged the large-cap Russell 1000 Growth Index. However, growth stocks can outperform for long stretches. Timing exposure between the two groups is difficult to do well.

The fund’s broad, market-cap-weighted portfolio diversifies risk and limits its exposure to speculative growth stocks. The top 10 holdings account for only about 6% of the portfolio. Market-cap weighting skews the portfolio toward the largest names in its target segment, which are not necessarily the fastest-growing. Indeed, the average market cap of the fund’s holdings is greater than the category average. But this weighting approach also promotes low turnover. Most of the fund’s sector weightings are similar to the category norm, but it has much greater exposure to the real estate sector and less exposure to financial services, technology, and healthcare stocks.

Portfolio Construction
The fund employs full replication to track the market-cap-weighted CRSP U.S. Small Cap Growth Index. CRSP defines small-cap stocks as those representing the 85th to 98th largest percentile of the U.S. stock market. It then assigns composite value and growth scores to each of these stocks using several metrics. The growth attributes include projected short- and long-term earnings per share growth, three-year historical earnings and sales per share growth, current investment/assets, and ROA. CRSP evaluates value on book/price ratio, forward and trailing earnings/price ratios, dividend yield, and sales/price ratio. It fully allocates stocks with the strongest growth characteristics to the small-cap growth index until it represents half the assets in the small-cap market.

CRSP keeps 100% of each stock in its respective style index until it passes through a buffer zone. At that point, it moves only 50% of the position from one style index to the other. If the stock stays on the opposite side of the buffer zone at the following quarterly review, CRSP will transfer the remaining half. This approach mitigates turnover where it does not significantly affect the fund's style characteristics.

Vanguard charges a razor-thin 0.08% expense ratio, making this the cheapest small-cap growth fund available to individual investors. The fund engages in securities lending, the practice of lending out the underlying holdings in exchange for a fee. This ancillary income partially offsets the fund's expenses. As a result, the fund actually outpaced its benchmark by 8 basis points during the trailing 12 months through June 2016.

IShares S&P Small-Cap 600 Growth IJT (0.25% expense ratio) and iShares Russell 2000 Growth IWO (0.25% expense ratio) climb further down the market-cap ladder but otherwise offer similar exposure to VBK. These funds target the faster-growing half of the U.S. small-cap market and weight their holdings by market capitalization. Given the similarities between these funds, the Vanguard fund is the most compelling because it is the cheapest of the three.

Guggenheim S&P SmallCap 600 Pure Growth RZG (0.35% expense ratio) offers a more-pronounced growth tilt. It applies more-stringent growth requirements than VBK and weights its holdings according to the strength of their growth characteristics. This approach will likely continue to make RZG more volatile than VBK.

DFA U.S. Small Cap Growth DSCGX (0.40% expense ratio) may offer a better way to get exposure to small-cap growth stocks. It tilts toward small-growth stocks with high profitability and low valuations relative to their peers. These characteristics have historically been associated with higher returns. However, individual investors can gain access to this fund only through a financial advisor or a platform, such as a 401(k).


Disclosure: Morningstar, Inc.'s Investment Management division licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.


Alex Bryan is an ETF analyst with Morningstar.

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