This ETF fills a big hole in my portfolio and presents a great opportunity.
I have been investing for about 15 years. During that time, most of my investments have been in individual stocks. However, I recently invested a significant amount of my assets, approximately 12%, in exchange-traded funds (ETFs).
ETFs provide exposure to market segments that I had no prior experience with. This was a big hole in my portfolio, but it’s a great opportunity for long-term investors. And that opportunity looks increasingly attractive in today’s market.
While I could have done some research to find out about specific stocks in this segment, there were several reasons why I felt ETFs would work better than relying on individual names. So, during the recent market decline, I purchased the following stocks. Avantis US Small Cap Value ETF (AVUV 0.39%).
Why I finally pulled the trigger
Small-cap stocks have fallen out of favor recently. When I say “recently” I mean the last 10 years. Small-cap value stocks are faring even worse.
The return method is as follows. Russell 2000 Value Index compare with S&P500 Over the past 10 years.
Data by YCharts.
Small-cap value stocks have underperformed large-cap stocks in seven of the past 10 calendar years.
This led to a large disparity in evaluation. According to data compiled by , small-cap stocks were trading at 17% below their historical average forward price-earnings ratio at the end of 2023. Meanwhile, large-cap stocks were trading 15% above their historical average. American century. This is evidenced by the Avantis US Small Cap ETF’s P/E of 7.8, compared to the S&P 500’s P/E of 26.2.
The gap in valuation between small- and large-cap stocks has never been this wide in decades. This suggests that small-cap stocks have much more upside than downside risk. This is especially true given very long-term historical trends.
Over the very long term, small-cap value stocks are the best-performing group of stocks in the investable market. It hasn’t worked out that way lately, but there are fundamental reasons why it should happen in the future. Specifically, small businesses should command a higher risk premium. That is, small businesses are typically riskier investments than large, established companies, and investors demand higher expected returns.
This risk premium has only recently increased due to the Federal Reserve’s interest rate policy designed to combat inflation. When interest rates rise, the risk-free rate rises and the risk premium rises. Therefore, if investors want higher returns in small-cap stocks over the long term, that means stock prices need to fall today so that they can generate higher returns in the future. But for long-term investors, it’s a buying opportunity.
Why I chose ETFs
Researching large-cap stocks is easy. In addition to the quarterly financial reports that all publicly traded companies are required to file, there are plenty of news reports and Wall Street analyst notes to read. These stocks are highly liquid, with thousands or millions of shares traded each day. In other words, the large-cap market is highly efficient.
Small-cap stocks are a different story. Relatively few people know about these companies, they aren’t often mentioned in the news, and few analysts follow them. As such, these companies are ripe for investors with an informational advantage.
I could build an information advantage over time by digging deep into annual reports or doing field research, but I don’t have the time or taste to do that. I’d rather stick to easily accessible news and information about my favorite big companies.
A much easier way is to buy ETFs that offer diversified exposure to small-cap value stocks. I’d be happy to pay a small fee if someone could do it for me.
Why this ETF?
Avantis US Small Cap Value ETF is technically an actively managed fund that seeks to outperform its benchmark index, the Russell 2000 Value Index. However, the stock selection method is passive.
The firm uses current valuations to overweight stocks with higher expected returns. One of its main metrics is profitability to book value, which looks at the ratio of operating income to book value (assets minus liabilities). Filtering the Russell 2000 by that criteria leaves 765 holdings. Its largest holding still accounts for less than 1% of its total portfolio.
I usually stay away from actively managed funds. That’s often because they don’t outperform their fees. Because Avantis’ 0.25% expense ratio is a low hurdle, and small-cap stocks trade less efficiently than large-cap stocks, I think the fund has an even better chance of outperforming its benchmark index.
Another deciding factor is that the Avantis US Small Cap Value ETF has greater exposure to the small-cap segment of the market than many other small-cap ETFs. For example, 58% of the company’s holdings fall into the small-cap category. Lucifer. By comparison, Vanguard Small Cap Value ETF invests just 33% of its assets in small-cap value stocks. (This is entirely due to the index Vanguard chooses to track the fund. Vanguard does a great job of tracking the index it chooses.)
Avantis pays slightly higher fees than other pure small-cap value index funds, but the cost is well worth it. Investors gain both greater exposure to the small-cap value segment of the market and the potential to outperform Avantis’ selection criteria.
