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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.

Alex Bryan is an ETF analyst with Morningstar.

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