4 ETFs to Consider From an Undervalued Part of the Market

Susan Dziubinski: Hi. I’m Susan Dziubinski with Morningstar. On a recent episode of The Morning Filter podcast, I interviewed Morningstar’s Bryan Armour about small-cap ETFs. Bryan is Morningstar’s director of ETF and passive strategies research for North America, and we chatted in early September. Here’s an excerpt from the podcast.

Now, Bryan, The Morning Filter’s audience is made up primarily of investors who are buying individual stocks. So make the case for why maybe when it comes to small-cap stocks, an individual stock investor might consider an ETF instead of just buying individual small-cap stocks outright.

Bryan Armour: Yeah, so the old saying is “diversification is only free lunch in investing.” So most small-cap stocks aren’t going to probably outperform in the long term. And so if you can hold hundreds or even thousands at once in one portfolio, that gives you access to the ones that do end up winning. And so it’s less about trying to pick the exact winners and just making sure you do hold the winners is the other side of that coin.

4 ETFs to Consider From an Undervalued Part of the Market

1. Vanguard Small-Cap ETF VB
2. iShares Core S&P Small-Cap ETF IJR
3. Dimensional US Small Cap ETF DFAS
4. Avantis US Small Cap Equity ETF AVSC

Dziubinski: And that you have exposure to that part of that market. Now, when researching a small-cap ETF that maybe an investor would want to buy, what are some of the key things that you think investors need to be paying attention to?

Armour: Yeah, so I would say cost is always a very important one. That comes up in two ways. Number one, fees. You can obviously get access for a cheaper fee for similar strategies. So always good to optimize for that. But also with small-cap stocks, especially with index funds, there’s more trading involved, especially in the lower bounds of the micro-cap stocks, those are more expensive to trade. So you want some sort of buffer or some sort of limitation on how much trading you’re going to actually be doing down there to try to avoid racking up trading costs for little economic purpose.

Dziubinski: Got it. Now, the bulk of ETF assets are held in passive index type products. But we have seen over the past several years quite a number of active ETFs coming to market. When it comes to the small-cap universe, is a small-cap index fund tend to make a little bit more sense, Do you think it makes—I know a lot of the active funds are newer, but does it make sense to consider an active ETF? What’s your take?

Armour: Yeah, so there’s a couple layers to this, and I do the Active/Passive Barometer for Morningstar, and so success rates are higher among passives. It’s typically lower for active in small-cap US stocks, but overall if you have a concentrated strategy, it can become more problematic in an ETF wrapper because unlike a mutual fund, you can’t close down to new investors, and so active ETFs that’ve really settled into the small-cap space and are the most popular tend to be broader portfolios, systematic selection, and tweaking other portfolios like from Dimensional Fund Advisors and Avantis, for example. So I would say index or some of these broad portfolio active.

Dziubinski: Yeah, where it’s not going to be as big of a deal what your flows are necessarily.

Armour: Yeah, you don’t want to worry about the concentration risk.

Dziubinski: When it comes to, say an investor does want to index the small-cap portion of the market, wants a passive strategy, are there certain indexes that are maybe better than others when it comes to that small-cap space?

Armour: I don’t know that I would say better. But there are different. There are a slight variations on trying to achieve the same thing. So there are different ways of doing it. It could either be count, like the S&P 600, which is like 901st to 1,500th biggest stocks in the US that meet the requirements, or Russell 2000, which is 1,001 to 3,000. But there’s also indexes like from CRSP that are percentage-based, so it’s 85th percentile to 98th percentile. So it could end up in different portfolio, like with different portfolios, different areas of the style box, a little bit, all small cap. I wouldn’t say one’s necessarily better than the other. But an issue for the Russell 2000 is the lack of buffers at the bottom of the market cap. And likewise for S&P, something they do a little bit differently is they require companies to be profitable to get into the S&P 1500, which is S&P 500, Mid-Cap 400, and Small-Cap 600. And so yeah there are different ways to approach it. But I think profitability and quality are good features for small-cap stocks.

Dziubinski: I guess the bottom line is first of all, understand the index that the ETF is tracking and second of all, take a good look at that portfolio because two small-cap ETFs could have very different, say, sector exposures or even be in different parts of the style box.

Armour: Absolutely.

Dziubinski: OK, now Morningstar has ETF flows data, and you touched a little bit on flows before. This year, we’ve seen a lot of small-cap ETFs in general being in outflows. If I’m a new investor to the small-cap space, I want to get a new small-cap ETF, but I hear they’re in outflows, what do I make of that? Is that a good or bad thing? Is it maybe a contrarian indicator? Does it mean anything at all if I’m looking to invest?

Armour: Yeah, a tough question. I would say it doesn’t necessarily mean anything, but it does show you where investors are putting their money. And if they’re taking money out of small caps, then it could be a good time to make a contrarian play. And so what we say in factor investing is “no pain, no premium.” So it has to almost go out of style to have the potential to outperform going forward. So yeah, not a bad time to be in small caps according to outflows.

Dziubinski: All right, then it’s time to name names. Tell us some of maybe a couple of Morningstar’s highest rated small-cap ETFs and why we like them.

Armour: All right, so on the market beta side, Vanguard Small-Cap ETF, which is ticker VB

, tracks a CRSP small cap index. And so that is a broad portfolio. It’s a good way to capture the small-cap market. All-in-one, single, supercheap 5-basis-point ETF. And then iShares Core S&P Small-Cap ETF IJR that would hold the S&P 600 Small Cap index. And so both of those are great options.

Also if you’re looking for more of a play on our price/fair value metric, which I know is something that on the stock side they talking about a lot, when you aggregate it up to the portfolio level, both of these are going to be undervalued compared to fair value. If you want to dive even deeper into that, then go small value. There’s a small-value version of both strategies as well.

Dziubinski: How about active small-cap ETFs? Any we like there?

Armour: Yeah. So we have two that we like more than the rest—Dimensional US Small Cap ETF, which is ticker DFAS, which receives a Gold rating, Silver-rated Avantis US Small Cap Equity ETF, AVSC. And both of those tilt toward value and profitability characteristics. They avoid asset growth. They take some of the guesswork out of—is this company actually growing, or is it burning their cash and going to be out of business soon? And so these are both very broad. They hold over 1,000 stocks each. Still relatively cheap, more like 25- to 30-basis-point range, but very solid options as well.

Dziubinski: Well, great. Thank you so much for your time.

Armour: Thanks for having me.

Watch Investors First: Inside Morningstar’s Semiliquid Fund Ratings for more from Kunal Kapoor and Bryan Armour.