With Small-Cap Value, Active Management Can Deliver

For what now feels like an eternity, active management in mutual fund for has taken its lumps in the court of public opinion, but broadly speaking, the performance just hasn’t been there to justify high fees and lack of tax benefits relative to passive fund structures.

However, there are a couple of important points to remember. There are some market segments in which active management can generate better outcomes for clients and investors. Second, exchange traded funds are breathing new life into active management.

Regarding areas of the equity market that are conducive to active manager success, it’s long been believed that small-caps are one of the prime spots. Part of the reason for that theory is that some traditional small-cap benchmarks don’t filter money-losing companies – a task active managers can and do accomplish.

Furthering the potential allure of the active/small-cap marriage is the point that there are myriad examples of it working well when factors, such as growth or value, or involved. For the purposes of what follows, I’ll examine two prominent examples of active management meeting small-cap value and delivering for clients via the ETF wrapper.

Small-Cap Value Has Lagged, But Not Here

As advisors know, it’s been a lengthy run of small-caps and value stocks trailing large-cap and growth rivals. For the three years ending May 20, the S&P SmallCap 600 Index returned just 4.4% while its vale counterpart was up a meager 1.6%.

With data points like those, it’d be easy to be dismissive of small-cap value, but in at least two cases, active management came to the rescue. During that same three-year span, the Avantis US Small Cap Value ETF (AVUV) and the Dimensional US Small Cap Value ETF (DFSV) returned an average of 25.7% with neither ETF subjecting investors to alarmingly higher levels of annualized volatility to the S&P SmallCap 600 Value Index.

DFSV is part of the rapidly growing roster of Dimensional Fund Advisors (DFA) ETFs, many of which were converted from the firm’s venerable lineup of actively managed mutual funds. Much of that fund’s success is attributable to risk mitigation – something that shouldn’t be overlooked when it comes to investing in smaller stocks.

“Dimensional’s portfolio managers start with the smallest 10% of US stocks, then pull in the cheapest 35% of those by price/book ratio,” notes Morningstar’s Bryan Armour. “They further avoid holding stocks with relatively low profitability and aggressive asset growth, as these traits tend to lead to poorer returns. This helps the ETF avoid the riskiest stocks in the small-value segment of the market.”

AVUV Awesome, Too

American Century’s AVUV turns five years old in September, making its status as an $11.44 billion ETF all the more impressive. It also has a lead over rival DFSV over the past three years. For advisors that know their fund industry history, AVUV’s advantage of DFSV is interesting because Avantis was once part of DFA.

That is to say AVUV does a few things similarly to the competing DFA fund, but these ETFs aren’t carbon copies of each other. They are, however, proving to be better bets than many passively managed equivalents.

“Avantis ratchets up the small size and value factors a bit more than Dimensional by pulling from the smallest 8% of the US market, then picking stocks with the best combination of value and cash-based profitability and tilting their weights toward those with the strongest traits,” concludes Armour.

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