Small-Cap Fund Representation in AAII Models

AAII’s asset allocation models use the Vanguard Small-Cap Index fund (VSMAX) and the Vanguard Small-Cap ETF (VB) as representations of the small-cap category. These funds follow the CRSP Small Cap index, which captures the small- to micro-cap market segment.

The Vanguard Small-Cap Index fund offers a well-diversified, low-turnover portfolio that is representative of the U.S. small-cap market. Transaction costs remain low as it avoids unnecessary turnover through its choice of index.

There are a number of small-cap indexes that mutual funds and ETFs track. One of the most prominent is the Russell 2000 index. It is constructed by excluding the biggest 1,000 stocks out of the largest 3,000 stocks traded on the domestic exchanges. The Russell 2000 is actually a subset of the Russell 3000 index, which is a cap-weighted index. Other noteworthy small-cap indexes include the S&P SmallCap 600 index and the Morningstar US Small Cap index.

The Vanguard mutual fund and ETF representing the small-cap holdings in the AAII asset allocation models both incorporate a blend of growth and value stocks. There are value and growth funds and ETFs for investors looking for return from a particular style of investing.

Value funds focus on cheap stocks using metrics such as the price-earnings ratio. Growth funds target firms with rapidly expanding earnings, such as technology stocks.

Small-cap value ETFs were outperforming small-cap growth and blend ETFs with a one-year annualized return of 37.2%, compared to 20.4% and 28.8%, respectively, as of November 30, 2021 (Table 2). But the small-cap value ETFs have underperformed over the last five years, with an annualized return over that period of 9.9%, compared to 11.0% and 15.3% for the blend and growth categories, respectively. Small-cap mutual funds exhibit the same pattern (Table 3).

Table 2. Top Small-Cap ETFs by Category (Ranked by 5-Year Return)
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The Vanguard small-cap mutual fund and ETF are near the top of their respective categories for five-year annualized return. Compared to their category peers, both have some of the largest total assets as well.

Their size influences the average market cap of the holdings in the Vanguard small-cap index portfolio. The holdings in both funds have an average market cap of $6.18 billion, which is outside the traditional conception of the upper limit on the market-cap identification of a small-cap stock, ranging into the traditional mid-cap category. Some of this may be explained across the category by small caps’ one-year return tied to the correction following the 2020 bear market.

Micro-Cap Stocks

Funds can invest in a wide and varying size range of companies as measured by market cap. This is especially true for the small-cap category. It is common to see small-cap funds move into the mid-cap segment if assets under management grow too much. Check the weighted average market cap of the portfolio holdings to ensure that the fund is a pure small-cap fund.

Some funds fall into the micro-cap range, which typically comprises companies with market caps below $600 million. The micro-cap category includes the largest number of companies compared to large-, mid- and small-cap categories, as can be seen in Table 1. But micro caps’ overall market share is extremely small, even smaller than that of small caps.

In terms of performance, micro caps tend to move in sync with the small stock universe—in or out of favor for extended periods.

Micro-cap companies carry more business and liquidity risk than larger firms. Perils include less news and analyst coverage, a narrower business focus, competition from larger companies and less access to financing.

In addition, ultra-small stocks are illiquid and generally more vulnerable to adverse shifts in market sentiment and economic conditions. Because micro caps have fewer shares outstanding and trade with lower volume than larger companies, the purchase or sale of shares by a fund could have a big impact on the price. Higher portfolio turnover in a small-cap fund tends to hurt its performance.

An investor employing a micro-cap strategy needs to be conscious of the small dollar volume of shares being traded to effectively pursue its objectives.

Evaluating an Active Fund

The best argument for an index fund is that the trading costs for illiquid small stocks can be quite high. With an index fund, you avoid the risk of picking a manager who underperforms. Traditionally, small-cap funds have been the space of active management. Because of their illiquidity and risk, it has most often been infeasible for a large fund to invest in smaller companies. Most smaller companies are destined to stay small, and it is the portfolio manager’s job to pick the most promising ones in terms of potential for price appreciation. Table 3 shows the active mutual funds with the best five-year performance as of November 30, grouped by style. Table 4 shows performance for index mutual funds, grouped by style and ranked by five-year return.

Table 3. Top Active Small-Cap Mutual Funds by Category (Ranked by 5-Year Return)
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Table 4. Small-Cap Index Mutual Funds (Ranked by 5-Year Return)
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Some investment strategies work equally well if total assets remain small or grow to many billions. Specialized approaches such as those used by actively managed small-cap mutual funds can become difficult to manage effectively if assets grow too large. Prudent managers may close their fund to investors and then reopen at a later date.

It is normally a good sign for investors holding a fund when a fund’s management decides to close to new investors. This indicates that management is placing the interests of investors over the additional fees that would be collected by having more dollars under management.

Actively managed funds tend to have higher expense ratios than index funds. What you pay the fund manager should result in their expertise adding value to make up for any extra expense compared to category peers. Small-cap funds often carry higher expense ratios, generally due to the area of the market they target.

Mutual funds mainly employ two fee structures. Annual fund operating expenses include the total cost of paying managers, accountants, legal fees and marketing.

Shareholder fees include any sales commissions and other one-time costs when investors trade their holdings. A high-turnover fund will also have higher expenses, passing on the cost of short-term transactions.

Avoid small-cap funds that charge any loads or sales commissions. ETFs have created competition for their mutual fund peers, putting pressure on fund managers to be mindful of their expenses. Other charges include the 12b-1 fee, an operational expense that should be reflected in a fund’s expense ratio. Evaluating the associated fees may change your strategy toward a small-cap index fund or ETF.

Remember that individual investors most benefit from investing in small caps when they stay invested for a long-term period, at least five years. This is a minimum period over which to meaningfully compare a fund or ETF’s management and return against that of its category peers.

It is easy for new funds to do well in their first year or two if market conditions are favorable. Long-term trends reveal the manager’s real strengths or weaknesses. A well-managed fund performs consistently relative to its peers over time. If your fund significantly lags its peers for three years or more, think about moving on.

Conclusion

Because small caps make up only one part of a diversified approach to asset allocation, consider your tolerance for risk when deciding how much exposure to them you want. Even though small caps offer exciting long-term potential, it may not be suitable for all investors to have them dominate their asset allocation. Remember the checklist for investing in a small-cap fund as enumerated at the beginning of this article.

In addition to the risk of short-term underperformance by small caps as a group, fund management risk exists because the small-cap market is so large in terms of the number of companies and less efficient relative to large-cap stocks. Both the size of a small-cap fund and the average market cap of companies it owns are important. You don’t want a large-cap fund that inadvertently drifts into the small-cap category, particularly if its performance is faltering.

Because small caps are illiquid, any advantage gained from the small-firm anomaly can be greatly diminished by the added transaction costs accompanying active trading.

Small caps can go through long periods underperforming the S&P 500, so you need a lengthy time horizon to be able to benefit from the stellar returns when they ultimately occur.