Cheap Exposure to Small-Value Stocks

Small-cap value stocks have historically represented the best-performing segment of the U.S. equity market.

This fund is not for the faint of heart. Small-cap stocks tend to be considerably more volatile than their large-cap counterparts. Many small-value stocks also carry high business risk and do not enjoy sustainable competitive advantages to cushion earnings during tough environments. Over the past decade, the fund was about 33% more volatile than the S&P 500. In light of these risks, this fund is most appropriate as a small holding for long-term investors with a relatively high risk tolerance.

Low valuations do not necessarily make a stock a bargain. A company's fair value is the present value of its future cash flows, plus the value of its financial assets, minus debt. Earnings growth is an important part of that equation. An investor should be willing to pay more for a company with higher expected growth. However, investors may extrapolate past growth too far into the future, or become overly pessimistic about a firm's prospects. This myopic focus can push the prices of slow-growing stocks below their fair values. Their depressed valuations can provide a margin of safety and attractive upside if they exceed expectations, which are low to begin with.

Because this fund covers approximately half of the small-cap market, it includes some small-blend stocks that dilute its value tilt. However, it has less overlap with its growth counterpart,

The fund's benchmark applies a more generous buffer zone to limit turnover than the indexes that

Fundamental View Value stocks have historically outperformed their growth counterparts in nearly every market studied over long horizons. From its inception in December 1978 through March 2015, the Russell 2000 Value Index outpaced the Russell 2000 Growth Index by about 3.4% annualized. Because more investors are aware of this performance gap and are seeking to exploit it, it will likely be smaller in the future. However, there is reason to believe the value premium will persist.

Some researchers have interpreted value stocks' higher returns as compensation for risk. This risk story is plausible. Relative to their growth counterparts, value stocks tend to be less profitable and have less attractive outlooks. However, they have historically offered better risk-adjusted returns. This lends credence to the view that investors may extrapolate past growth too far into the future. This can create systematic mispricing that may partially explain the value premium. While the fund includes some small-blend stocks that dilute its exposure to the value premium, its style tilt should modestly boost returns over the long run. These holdings may also help reduce volatility relative to a more exaggerated value portfolio.

Value stocks' return advantage over growth stocks has historically been the largest among small-cap stocks. This may be because fewer Wall Street analysts cover these stocks, creating greater chances for mispricing than in the large-cap arena. Small-cap value stocks have historically outperformed their larger counterparts over the long run. In contrast, the most expensive small-cap growth stocks trailed their large-cap counterparts.

Despite value stocks’ attractive long-term record and the rationale for their edge, they can lag pricier growth stocks even over long stretches. While value stocks may have a reasonable chance to outperform over the long term, there is no guarantee that they will. Low fees give the fund a sustainable edge against its peers and will benefit investors even when value stocks are out-of-favor.

At the end of March, the constituents in the fund's index were trading at a lower multiple of forward earnings (17.5) than its growth counterpart (27.2). This was larger than the average valuation gap between the two funds over the past decade. Differences in expected growth rates justify at least part of this valuation gap.

Portfolio Construction The CRSP US Small Cap Value Index forms the foundation of the fund's portfolio. CRSP defines small-cap stocks as those smaller than the largest 85% of the U.S. stock market by market capitalization and larger than the smallest 2%. It then assigns composite value and growth scores to each of these stocks using several metrics. The growth metrics include projected short- and long-term EPS growth, three-year historical earnings and sales per share growth, current investment/assets, and return on assets. CRSP evaluates value on book/price, forward and trailing earnings/price, dividend yield, and sales/price. It fully allocates stocks with the most dominant value characteristics to the small-cap value index until it represents half the assets in the small-cap market.

In order to mitigate turnover, the fund's benchmark keeps 100% of each stock in its respective style index until it passes through a buffer zone. At that point, CRSP only moves 50% of the stock 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 should reduce turnover where it does not significantly impact the fund's style orientation.

Alternatives IWN (0.25% expense ratio) and IJS (0.25% expense ratio) offer similar exposure. Like VBR, these funds both target the cheaper half of the U.S. small-cap market and weight their holdings by market capitalization. However, they climb further down the market-cap ladder.

Guggenheim S&P SmallCap 600 Pure Value ETF RZV (0.36% expense ratio) may be more attractive to investors looking for a deeper value tilt. It targets the cheapest third of the S&P SmallCap 600 Index and weights its holdings according to the strength of their value characteristics. However, this approach may increase the fund’s exposure to stocks with deteriorating fundamentals. It also brings RZV deeper into micro-cap territory than its peers.

Although it doesn't specifically target value stocks,

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