It’s been incredibly challenging to be a small-cap investor since 2021. Most small stocks are still trading below their respective 2021 highs, and large-caps have been all the rage. Passive, to put it simply, failed as an investment style for this segment of the stock market. But active value investing in small-cap stocks? That’s actually had a very different outcome. And one fund that has crushed it with that style is the Avantis US Small Cap Value ETF (NYSEARCA:AVUV).
Rather than being a passive index-tracking fund, AVUV uses a rule-based strategy that marries the benefits of indexing (low turnover and efficient diversification) with the ability to add value through active decision-making. In essence, the fund’s managers take current market prices and company financials to help them identify securities that are more likely to produce the highest return given certain factors, such as low valuations and high profitability ratios.
The high profitability ratios part of this is critical, as it largely removes so-called “zombie companies” which are loaded with debt and have low margins, putting into question their ability to survive in a higher for longer interest rate environment.
A Look At The Holdings
One thing I appreciate about the fund is its diversity. It currently has 761 holdings, with no position making up more than 1.19% of the portfolio. Highly diversified overall, which in general I favor independent of what market-cap segment you’re trading/investing in at this point in the cycle.
Obviously, these positions cover a wide range of companies. Abercrombie & Fitch Co. (ANF), for example, is a specialty retailer in the consumer discretionary sector, while KB Home (KBH) is a home builder, and SM Energy (SM) serves as a natural gas and oil producer in the energy sector.
Sector Breakdown
The top 3 sectors here are not what you typically find in large-cap portfolios.
Financials make up the largest allocation, followed by Consumer Discretionary and Industrials. Notice Tech makes up just 5% of the fund overall, which I think candidly is perfect if you’re bullish on equities but bearish on Tech given not just how overvalued the sector is currently, but also how crowded that trade is. Some might be concerned with the Financials and Consumer Discretionary side given the regional banking crisis of last year and consumer strength. I share similar concerns, but the focus on profitability ratios and valuations should mitigate much of the risks those two sectors in particular have,
Peer Comparison
One fund worth comparing this against is the iShares Russell 2000 Value ETF (IWN), which follows the Russell 2000 Value Index. Consider this like a battle between passive and active investing. When we look at the price ratio of the two against each other, we find that the performance doesn’t even come close. AVUV substantially has outperformed. Active, it would appear, very much works in this cycle for small-cap value investing.
The active management at AVUV, which allows fund managers to identify and buy stocks they think have bigger potential returns (based on factors such as profitability and valuation), likely explains the fund’s outperformance. So does the fact that AVUV’s stocks tend to have smaller market capitalizations, and that it spreads returns across many different sectors.
Pros and Cons
The positive side? A rare case where active stock selection works. Rather than select companies that might be susceptible to an economic downturn, AVUV’s equity analysis and proprietary stock-selection focus on profitability and other value characteristics has led to significantly improved fund performance. Moreover, AVUV’s breadth across many sectors and industries reduces concentration risk and allocates exposure across as many growth opportunities as possible.
But investing in small-cap value stocks is riskier than investing in large-cap or broad market stocks. Smaller companies are more volatile and more exposed to market volatility than their larger counterparts, as they typically have fewer resources, fewer product lines and fewer markets for their products. The value investing style can also lag behind growth stocks when the market is favoring those types of stocks, as is the case currently.
Moreover, because it is an actively managed fund, AVUV’s returns will hinge entirely on the skill of its managers to make good decisions. Although the fund has performed well to date, this doesn’t guarantee that its managers will continue to make sound judgments and exploit market opportunities successfully.
Conclusion
Not going to lie – impressive overall. This fund made the small-cap value segment of the market appealing, which is hard to do. AVUV is a solid fund, seems to be hitting on all cylinders, and is doing so when there hasn’t been a major tailwind to favor small-caps broadly. I see a bright future here, and think this is worth carefully considering as large-cap momentum, eventually, fades alongside growth.
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