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ETF Specialist

A Small-Value ETF With an Eye on Profitability

This exchange-traded fund filters out some distressed stocks, but there are cheaper alternatives.

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 IShares S&P Small-Cap 600 Value (IJS) offers well-diversified, market-cap-weighted exposure to small-cap value stocks and screens out some unprofitable names. It also has a considerable cost advantage against its actively managed peers. However, there are cheaper index alternatives, including a couple that track this fund's index, which limits its Morningstar Analyst Rating to Bronze.

The fund targets stocks representing the cheaper and slower-growing half of the S&P SmallCap 600 Index. This sweeps in more than 400 stocks such as Express (EXPR), Finish Line (FINL), and restaurant operator Bob Evans Farms (BOBE). Most of these firms have limited analyst coverage and do not enjoy sustainable competitive advantages. They also tend to have less attractive business prospects than their growth counterparts, so they are not necessarily bargains. But they could become undervalued if investors extrapolate lackluster past growth too far into the future. The fund's holdings are clearly riskier than their larger counterparts, but they should have greater return potential over the long term.

Because the fund casts a wide net, it includes some stocks with modest value characteristics. These holdings may help reduce volatility. Nearly a third of the fund's holdings overlap with its growth counterpart,  iShares S&P Small-Cap 600 Growth (IJT). As a result, its holdings tend to trade at a slightly higher average multiple of forward earnings than the small-value Morningstar Category average. But the portfolio has a similar market-cap orientation.

Unlike value index funds derived from the Russell 2000 Index and CRSP U.S. Small Cap Index, S&P requires new constituents in the fund's parent benchmark to have positive net income over the previous four quarters. This requirement reduces the fund's exposure to firms in severe financial distress. S&P may also consider other measures of financial viability, such as leverage.

Low fees give the fund a durable edge. This cost advantage helped it outpace the category average by 139 basis points annualized over the trailing 10 years through December 2016. More-favorable stock exposure in the consumer cyclical sector also contributed.

Fundamental View
Small-cap value stocks have a good long-term record. From its inception in December 1978 through December 2016, the Russell 2000 Value Index (which offers similar exposure to this fund) outpaced the Russell 2000 Growth Index by about 3.7 percentage points annually. This outperformance has not been consistent. Over the past 10 years, the Russell 2000 Value Index lagged its growth counterpart by 1.5 percentage points annualized. While they won't always come out ahead, value stocks will likely offer a modest return edge over the long term.

Investors may require higher expected returns to own value stocks, which have less-attractive business prospects than their growth counterparts and could be riskier. Value stocks tend to be less profitable, grow more slowly, and are less likely to enjoy sustainable competitive advantages than growth stocks. For example, the fund's holdings consistently generate lower average returns on invested capital than those in iShares S&P Small-Cap 600 Growth.

Although the fund's holdings often trade at low valuations for good reason, they could become undervalued if investors extrapolate past growth--or lack thereof--too far into the future. The return advantage from tilting toward value stocks has historically been the most pronounced among the smallest stocks. Small-cap stocks may be more likely to be mispriced than their larger counterparts because they don't attract as much attention. But larger differences in required return could also contribute. Small-value stocks have historically outperformed their larger counterparts, while the same was not true of small-growth stocks in the United States. 

This broad, market-cap-weighted portfolio offers a moderate value tilt and limited exposure to firm-specific risk. Its top 10 holdings account for just 8% of its assets. Market-cap-weighting skews the portfolio toward the larger small-cap value stocks, which are not necessarily the cheapest. However, this approach helps reduce risk and foster low turnover. Turnover here has been a bit higher than at comparable index funds, though it is still well under the category average. Because the fund's parent index is managed by committee, which does not follow rigid rules, it can be difficult to predict changes to the portfolio.

At the end of December 2016, the fund's holdings were trading at slightly higher multiples of forward earnings and book value than the small-value category average. But they had a similar average market capitalization. A more exaggerated value or small-cap tilt might increase expected returns, but would also increase risk.

Most of the fund's sector weightings are similar to the category norm. However, it has greater exposure to the consumer cyclical and healthcare sectors, and less exposure to financial stocks. Like most of its peers, the fund overweights the financial-services sector and underweights the faster-growing technology and healthcare sectors relative to the broad S&P SmallCap 600 Index. The fund does not constrain its sector weightings or make any sector-relative valuation adjustments.

Portfolio Construction
The fund employs full replication to track the market-cap-weighted S&P SmallCap 600 Value Index. This index effectively diversifies risk and accurately reflects the composition of its target market segment, supporting the Positive Process Pillar rating.

S&P assigns composite value and growth scores to each stock in the S&P SmallCap 600 Index using three value metrics (price/book, price/sales, and price/earnings) and three growth metrics (12-month price momentum, three-year change in earnings scaled by price, and three-year sales per share growth). It then ranks each stock by the ratio of its growth score to its value score and fully allocates those with the lowest scores to the value index until it represents a third of the parent index's assets, while those in the top third go exclusively to the growth index. S&P partially allocates stocks that fall in between these cutoffs to both the value and growth indexes, based on the relative strength of the stock's value and growth characteristics. While these indexes each usually represent close to half of the assets in the S&P SmallCap 600 Index, it is possible for one index to represent a larger portion of this parent benchmark than the other. S&P rebalances the value and growth indexes annually in December.

The fund levies a 0.25% expense ratio, which is low relative to the small-value category, supporting the Positive Price Pillar rating. But there are cheaper index alternatives. For example, Vanguard S&P Small-Cap 600 ETF (VIOO) and SPDR S&P 600 Small Cap ETF (SLY) track the same index for a lower 0.15% expense ratio. 

The managers generate ancillary income for the fund through securities lending, which partially offsets the fund's expenses. Consequently, it only lagged its benchmark by 10 basis points annually over the trailing three years through December 2016.

 Vanguard Small-Cap Value ETF (VBR) (0.08% expense ratio) and  iShares Russell 2000 Value (IWN) (0.25% expense ratio) offer similar exposure. Both of these funds target the cheaper half of the small-cap market and weight their holdings by market capitalization. VBR climbs further up the market-cap ladder but has less overlap with its growth counterpart than IJS. IWN offers a closer market-cap orientation to IJS. The Vanguard fund is the most compelling of the three because of its low expense ratio and the generous buffering rules that its benchmark applies to mitigate turnover.

 WisdomTree SmallCap Dividend ETF (DES) (0.38% expense ratio) offers an alternative way to get exposure to small-value stocks. It targets small-cap dividend-paying stocks and weights each stock based on the dividends it is expected to pay out during the next year relative to the aggregate figure for the portfolio. When it rebalances, DES increases its exposure to companies that have become cheaper relative to their dividends, and it trims positions in stocks that have become more expensive against this metric. 

 PowerShares FTSE RAFI US 1500 Small-Mid (PRFZ) (0.39% expense ratio) also trades against the market when it rebalances. It weights holdings on fundamental measures of size, including sales, cash flow, book value, and dividends. PRFZ rebalances into stocks as they become cheaper relative to these metrics and their peers, and reduces exposure to those that become more expensive. This should help the fund benefit from mean-reversion in valuations.


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Alex Bryan has a position in the following securities mentioned above: VBR. Find out about Morningstar’s editorial policies.