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3 of the Best Small-Value Funds Today

Wed, 2 Sep 2015

American Beacon Small Cap Value and Diamond Hill Small Cap are two strong active options that are still accepting new investors, while Vanguard Small Cap Value is a great passive choice, says Morningstar's Russ Kinnel.

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Video Transcript

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. The small-cap value category is the worst-performing diversified domestic-equity category over almost every trailing time period. Joining me to discuss the case for small-cap value and to share some small-cap value fund picks is Russ Kinnel--he is director of fund research for Morningstar.

Russ, thank you so much for being here.

Russ Kinnel: Good to be here.

Benz: Russ, looking at these performance statistics, small-cap value really hasn't been the place to be during this current rally. But let's discuss the case for making a place in your portfolio for this category. There's certainly some long-term data that point to the value of having small-value stocks, but even maybe contrarians might be looking at small value right now.

Kinnel: That's right. As a contrarian, you might remember that the last time small value really lagged was in 2000 and, at that point, it would have been the best place to invest. I don't think it's as extreme an underperformance as that time, but there's still a good reason to go in. Also, even though there's a little bit of small-cap risk compared with large, small value tends to be fairly sleepy, so you're not really adding a lot of risk. You're getting some good diversifiers when you go into small value.

Benz: The tricky part for fund investors looking at this category is that a lot of our favorite funds are closed to new investors. Let's discuss why it's so important for small-cap funds, in general, to keep an eye on capacity. Also, before we get into some of the open funds that you would recommend, let's discuss some of the good funds that are closed today.

Kinnel: So, many of the small-cap funds do close to new investors. The reason is that small caps don't have a lot of liquidity; there can be a bigger bid-ask spread. What that means is, as a small-cap fund gets larger, it may incur more trading costs; it may have to start avoiding more and more of the small-cap universe as it moves up and gets bigger. So, there are a number of ways it can cause performance to deteriorate.

Benz: So, you've got good funds like T. Rowe Price Small-Cap Value (PRSVX)--

Kinnel: Also, Royce Special Equity (RYSEX), Fidelity Small Cap Discovery (FSCRX), Fidelity Small Cap Value (FCPVX)--a lot of our favorites are closed. That's a great sign of stewardship; but, of course, that leaves you out of luck if you're buying your small-value fund now.

Benz: So, you brought a list of funds that you and the analyst team like quite a bit. Let's start with American Beacon Small Cap Value (AVFIX). It recently got an upgrade, so it's a Morningstar Medalist now. It's a Bronze-rated fund, and it's a multimanager fund. Let's discuss the fund and why that multimanager strategy maybe lends itself well to the small-cap universe.

Kinnel: That's right. One way to combat that problem with capacity is to have multiple subadvisors managing money so that you can spread it out among a number of managers. So, even if, say, one of them hits their capacity, you've still got others who can handle that. This is a fund that we used to like a lot more because it had picked some really good subadvisors. Then, it added a bunch of subadvisors in anticipation of having asset growth, and we became less thrilled with it. But it has kind of come full-circle. It's gotten smaller, and it's now back to a smaller group of good subadvisors. The performance has followed as well. So, it's a nice, straightforward small-value fund. You're getting hundreds of names, so it's not going to be a real stock-picker's fund; but it's going to be a good way to get exposure to small value.

Benz: Another fund on your list is Diamond Hill Small Cap (DHSCX). This is a very high-conviction fund for you and the team. It's rated Gold, currently. Let's talk about that fund.

Kinnel: That's right. It really hits all of the boxes when you're looking for a good small-cap fund. You want one where assets aren't too big, where individual stocks still matter, and a really strong track record from the manager. Tom Schindler has built a really good track record at this fund; it's a classic [Benjamin Graham and David Dodd] approach of holding a relatively concentrated portfolio of stocks trading at discounts to their own estimates of intrinsic value. Over a number of years, it's done quite well. I also like the fact that it's kept an eye on capacity. They say that capacity is something like $1.5 billion to $2 billion; so when they get there, they are going to close the fund. That's another great thing to look for in a small-cap fund: a manager who is on top of that issue. He is already out there saying at what point they are going to close the fund.

Benz: Diamond Hill also has a small/mid-cap fund. Is that run kind of in the same strategy as this one?

Kinnel: Yeah. All Diamond Hill funds are kind of in that basic Graham-and-Dodd value strategy. But as you say, it is pretty small.

Benz: Let's discuss the last one: This is Vanguard Small Cap Value Index (VISVX). I think investors who are active-management enthusiasts might say that small-cap value is probably not a great place to index, but you and the team have this fund at a Silver rating, currently. That's a pretty strong endorsement.

Kinnel: Low costs still go a long way even in small caps. I think Vanguard, over time, has gotten better at indexing in small caps. It's a little trickier for the reasons I mentioned with the bid-ask spreads. So, they've changed indexes and, over time, turnover has come down. Ten years ago, it was 28% and it was a 3-star fund; now, it's 12% and a 5-star fund. That's not completely because of turnover, but I think they do a pretty good job. It's hard to ignore the success that passive investing has had. And again, it makes sense when there aren't a lot of good active options that are open.

Benz: Russ, thank you so much for being here to share your insights.

Kinnel: You're welcome.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

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