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ETF Investing

What is a Small Cap Value ETF?

No, it’s not an oxymoron: there is such a thing as a small cap value ETF! Most investors don’t tend to associate small cap stocks with value stocks, but there is a healthy cross-section. The purpose of an ETF is to bring together these undervalued companies in the ultimate hedge against small cap volatility. The hope is that while they’re undervalued for now, these companies will soon generate big ROI for investors savvy enough to seek them out. 

The caveat of small cap value ETFs is that they’re subject to more scrutiny from investors. Everyone has a different benchmark for a “value stock.” This benchmark is even harder to determine for small cap companies. Before you plunk your money into an ETF of undervalued small caps, it’s worth looking at the product to make sure your definitions of “value” are the same. 

Researching a small cap value ETF

Small Cap Value ETF Definition

The fundamental idea behind a small cap value ETF is that the assets under management are all undervalued in some way. This is where things can get tricky. What does “undervalued” mean? It depends on the fund manager’s definition. Some examples of an undervalued security include:

  • The market capitalization is less than its perceived intrinsic value
  • Market capitalization that’s less than book value
  • The market capitalization is less than comparable companies

For example, if the average P/E ratio for small cap energy stocks is 12.15 and XYZ Company trades at a P/E ratio of 6.80, it may signal a low valuation. Likewise, if a company’s P/B ratio is less than one, it’s a classic undervalued signal. Fund managers will look at these factors and myriad others when managing an ETF. The criteria for inclusion vary across funds.

The bottom line is that small cap value ETFs will include small cap companies deemed undervalued by some metric. You just might not always know what that metric is.

The Best Small Cap Value ETFs By Performance

There are a fair few small cap value funds out there to invest in. As is the case with most small cap ETFs, the ones managed by classic institutional funds tend to do better. Value-minded investors should look for funds that specifically target overlooked small cap companies. Some of the best examples include:

  • Vanguard Small Cap Value ETF (VBR)
  • Avantis U.S. Small Cap Value ETF (AVUV)
  • iShares Morningstar Small-Cap Value ETF (ISCV)

The goal of managed ETFs is to cultivate market-beating returns. Value-driven funds hope to do this by capitalizing on companies worth more than they’re currently trading for. Like most ETFs, this means a revolving door of assets under management. As companies become correctly valued (or overvalued), they’ll leave the fund. The same holds true for small caps that become mid and large cap companies. The good news is that there are always undervalued small caps to take their place. 

How to Determine Value in a Small Cap ETF

There are a few different indicators that signal a value-minded small cap ETF. First is the composition of companies. These are companies that track in the bottom 10% of major indices, representing small caps. Moreover, they’ll likely pace an aggregate segment of a small cap index like the Russell 2000. The idea is that the companies represented are undervalued through a traditional metric like P/E or P/B. 

Next, part of the value in an ETF comes from looking at its fees. Managed funds can average fees as high as one percent or more. Value funds tend to offer fees much lower—generally less than 0.25%. This helps investors maintain their ROI on the investment. This, combined with the mitigated volatility of an ETF adds intrinsic value.  

Finally, the real value in any ETF comes from its performance. Value ETFs may pace the market, but their true value comes from doing it consistently. Over the course of 12 months, small caps may see a swing of 20% from lows to highs. A value ETF should be much more indicative of a trend line—fluctuating only 10% over that same time frame, for example. There’s value in consistency, especially when it comes to small caps. 

Are Small Cap Value ETFs Safe?

Of the many types of small cap ETFs out there, value-driven funds are among the safest. A focus on value is unequivocally tied to risk mitigation: something an ETF offers anyway. Small cap value ETFs that tap into the undervalued nature of budding companies will flourish as valuation catches up to them. Moreover, they’re already hedged against market instability since they’re trading at a discount.

While there aren’t too many small cap value funds to choose from, it’s indicative of the opportunities they offer to investors. There’s stability and opportunity for profit if and when an accurate valuation comes to pass. 

The Bottom Line on Small Cap Value ETFs

They’re rare, but small cap value ETFs do exist. It’s up to investors to discern if the companies within an ETF meet their definition of value. Are they undervalued in comparison to an index or outright against book value? Why are they undervalued? Fundamentals play a big part in mitigating the risk of investing in small caps. 

To learn more about ETF investing, sign up for the Liberty Through Wealth e-letter below. These experts provide updates and analysis for various exchange-traded funds and stocks alike.

If you’re a value investor with a love of small caps, there are more than a few investment options out there. Holding an ETF full of them is a great way to punch your ticket to profitability when the market catches up and values them accordingly.

Read Next: Small Cap vs. Large Cap: What’s The Difference?


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