In finance, certain research papers leave an important mark, changing the course of investment theories and practices.
For example, consider the 1952 introduction of Modern Portfolio Theory, spearheaded by the late Nobel Prize laureate Harry Markowitz.
Another groundbreaking study emerged in 1992 when University of Chicago researchers Eugene Fama and Kenneth French proposed the existence of three investment factors that could predict asset returns. In simple terms, a “factor” can be understood as a characteristic or set of characteristics that influence an asset’s risk and return.
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Fama and French’s initial three-factor model started with the market factor, which represents the excess return of a broad market portfolio over a risk-free rate, suggesting that riskier assets should, on average, deliver higher returns than their less risky counterparts.
It also introduced the size factor, indicating that smaller companies, or small-cap stocks, generally have higher expected returns than their larger counterparts due to their inherently higher risk.
Lastly, the model incorporated the value factor, positing that stocks with low prices relative to their book value typically outperform those with high prices in relation to their value.
The implications of the Fama-French three-factor model were profound. It didn’t just lay the groundwork for asset pricing models but also highlighted that the size and value factors held statistical significance in predicting excess equity returns.
“Small-cap stocks and value stocks are two equity classes that have outperformed other equity classes over the long run,” says Derek Horstmeyer, professor of finance at George Mason University School of Business. “This result follows from Fama and French’s famous findings.”
This revelation meant that by weaving these factors into their investment strategies, investors could potentially reap returns surpassing those foreseen by just the market factor.
For example, from Jan. 1, 1972 to July 31, 2023, U.S. small-cap value stocks have returned an annualized 13.6%, compared to the 10.5% return of the overall U.S. stock market.
Fast forward nearly three decades later, and the world of investing has morphed significantly. With the proliferation of financial technology, exchange-traded funds, or ETFs, have now emerged as the go-to investment vehicles for many factor investors.
Leveraging Fama and French’s foundational insights, several ETF managers now provide investors with affordable and transparent avenues to delve into small-cap value investing.
Whether through index tracking, rules-based “smart beta” methodologies or even actively managed strategies, these ETFs present a variety of options for those eager to leverage the size and value factors.
Here are seven of the best small-cap value ETFs to buy in 2023:
| ETF | Assets under management | Expense ratio |
| Vanguard Small-Cap Value ETF (ticker: VBR) | $26.3 billion | 0.07% |
| SPDR S&P 600 Small Cap Value ETF (SLYV) | $3.8 billion | 0.15% |
| iShares Russell 2000 Value ETF (IWN) | $11.1 billion | 0.24% |
| Avantis U.S. Small Cap Value ETF (AVUV) | $6.7 billion | 0.25% |
| Avantis International Small Cap Value ETF (AVDV) | $3.3 billion | 0.36% |
| Avantis All Equity Markets Value ETF (AVGV) | $15.2 million | 0.26% |
| Dimensional U.S. Small Cap Value ETF (DFSV) | $1.6 billion | 0.31% |
Vanguard Small-Cap Value ETF (VBR)
“Small-cap value is currently trading at almost a 45% discount to its 20-year average valuation levels, and such an enormous discount has only happened three other times over the past 32 years,” says Thomas Mudge, senior vice president and director of equity research at Bailard. “In each other instance, these discounts were followed by strong subsequent returns, averaging 57% over the next 12 months, and 120% over the following three years.”
Investors looking for a low-cost, passively managed ETF for small-cap value exposure may like VBR, which tracks the CRSP U.S. Small Cap Value Index for a low 0.07% expense ratio. That translates to $7 per year for every $10,000 invested. This ETF is highly diversified, with over 850 holdings at present. The ETF is also available as a mutual fund in the form of the Vanguard Small-Cap Value Index Fund Admiral Shares (VSIAX).
SPDR S&P 600 Small Cap Value ETF (SLYV)
“While investors have long recognized these two sources of excess return, we believe that the small-cap value anomaly will not be arbitraged away due to ongoing behavioral biases and the sporadic nature of the outperformance,” Mudge says. “Large-cap stocks and growth stocks tend to receive lots of investor attention and almost inevitably end up with high expectations built into their valuations.”
Investors favoring a small-cap value tilt must therefore be able to stay the course and remain invested even when large-cap growth stocks pull ahead, as they did in recent years. For a buy-and-hold fund, consider an ETF like SLYV, which tracks the S&P SmallCap 600 Index and has been in operation since 2000. The ETF charges a 0.15% expense ratio.
iShares Russell 2000 Value ETF (IWN)
“Investment success hinges upon exceeding expectations — the higher the expectations, the tougher they are to exceed,” Mudge says. “Large-cap growth stocks tend to be burdened by lofty expectations that are reflected in their valuation, while small-cap value stocks are just the opposite, largely blessed with low valuations that mirror investors’ low expectations.”
Another popular passive ETF for small-cap value investing is IWN, which tracks the Russell 2000 Value Index. This index screens its portfolio of 1,400-plus stocks from the broader Russell 2000 index based on value characteristics, such as a lower price-to-book and price-to-earnings ratio. It has a track record dating back to 2000 and currently charges a 0.24% expense ratio.
Avantis U.S. Small Cap Value ETF (AVUV)
“There are many definitions of small caps, and some are not so small in market capitalization,” says Eduardo Repetto, chief investment officer at Avantis Investors. “For example, as of July 31, according to Morningstar, the CRSP (U.S.) Small Cap Index, which includes companies that many investors would consider to be even larger than midcaps, has an average market capitalization of $5.6 billion, while the Russell 2000 index has an average market capitalization of $2.3 billion.”
Investors looking for greater exposure to the size factor may prefer an actively managed small-cap value and AVUV. “Like the Russell indices, we prefer a more focused definition of small caps to get the desired exposure to companies expected to deliver higher premiums,” Repetto says. “AVUV has an average market capitalization of $2.3 billion, with more attractive valuation metrics than its benchmark, the Russell 2000 Value Index.” The ETF charges a 0.25% expense ratio, 0.01% higher than IWN.
[SEE: 10 Best Value Stocks to Buy for 2022.]
Avantis International Small Cap Value ETF (AVDV)
“Avantis ETFs are active, which means that we are not tied to an index and their arbitrary rebalancing dates,” Repetto says. “We buy securities because they are expected to add value to the portfolio, and we are also not forced to continue holding securities if they have already enjoyed the expected price appreciation and their future expected prospects are no longer as attractive.”
To complement AVUV with international diversification, investors can buy AVDV. Like AVUV, this ETF screens small-cap stocks for lower valuations and higher profitability ratios. Currently, the ETF has over 1,300 holdings and has accrued around $3.3 billion in assets, making it one of the more popular international small-cap value ETFs. AVDV charges a 0.36% expense ratio.
Avantis All Equity Markets Value ETF (AVGV)
“Any small-cap strategy is expected to buy securities at a low price and to sell them when the price goes up, so from the capital gains point of view buying low and selling high generates a lot of taxes,” Repetto says. “Using an ETF allows for very efficient rebalancing of small-value strategies that is very tax-friendly and is expected to minimize or eliminate capital gains distributions, allowing investors to realize better compounded returns due to the tax deferral.”
A great example of this in play is AVGV, which employs an “ETFs of ETFs” strategy by wrapping five other Avantis ETFs. Currently, this includes a 21% allocation to AVUV and a 10% allocation to AVDV, with the rest spread out among U.S., international and emerging market large-cap value. With AVGV, investors get a small-cap-value-tilted, globally diversified and all-in-one ETF at a 0.26% expense ratio.
Dimensional U.S. Small Cap Value ETF (DFSV)
Dimensional Fund Advisors has long been regarded as a pioneer in factor investing. It has an extensive mutual fund lineup, and Fama and French serve on its board of directors. In recent years, the firm has aggressively expanded its ETF offerings, with DFSV emerging as a popular option for U.S. small-cap value exposure. The fund’s performance has so far beaten its benchmark, the Russell 2000 Value Index. It charges a 0.31% expense ratio.
“Dimensional has over 30 years’ experience managing small-cap value strategies that go beyond indexing with a daily systematic investment process,” says Wes Crill, senior investment director and vice president at Dimensional. “Investing in small-cap value stocks offers a sensible proposition for outperforming the equity benchmarks: All else being equal, paying a lower price for a stock and its future cash flows can lead to a higher expected return.”
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7 Small-Cap Value ETFs to Buy in 2023 originally appeared on usnews.com
