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A Cheap, Silver-Rated Small-Cap Value Fund

Alex Bryan, CFA

Alex Bryan: Vanguard Small Cap Value ETF is one of the cheapest small-cap value funds available, which supports its Morningstar Analyst Rating of Silver. It targets stocks representing the cheaper and slower growing half of the U.S. small-cap market and weights them by market capitalization. 

This approach promotes low turnover, effectively diversifies risk, and accurately represents the opportunity set available to active managers. The resulting portfolio includes just over 800 holdings such as JetBlue, Rite Aid, and Barnes & Noble. Most of these firms do not enjoy sustainable competitive advantages. They also tend to have poor growth prospects and, in many cases, limited profitability, so they are not necessarily bargains. But they could become undervalued if investors extrapolate lackluster past growth too far into the future.

Small-cap stocks have indeed historically compensated investors for their risks over the long term. From its inception in December 1978 through March 2017, the Russell 2000 Value Index (which offers similar exposure to this fund) outpaced the Russell 2000 Growth Index by about 3.5 percentage points per year. This outperformance has not been consistent. During the past decade, the Russell 2000 Value Index lagged its growth counterpart by 2 percentage points annually. While they won't always come out ahead, value stocks will likely offer a modest return edge over the long term.

While the fund's style orientation and sector composition often look a lot like the small-value category norm, the fund's razor-thin 8 basis-points expense ratio gives it a sustainable edge. This cost advantage helped the fund outpace the category average by 136 basis points annually during the past decade through March 2017, and will likely continue to set up attractive category relative performance.