Vanguard Small-Cap: What’s in a Name? by Steve Abramowitz

In two previous posts (“The Morningstar Experience” and “Your Morningstar Freebee”), we looked at how readers considering investment in a Vanguard fund can consult the helpful information in Morningstar’s esteemed advisory service. We demonstrated how they might consult this resource to monitor their investments and evaluate their performance. Today, we’ll illustrate how to decide whether the holdings of the fund meet the reader’s objective. Once again, the fund examined is Vanguard’s Small-Cap ETF (symbol VB, or VSMAX for the mutual fund alternative).

We begin by searching our target fund—even without the $249 subscription price—and slide over to Portfolio. You can see that the stocks in VB are overwhelmingly domestic, as they should be. I find the map designating Stock Style confusing, so I recommend you drop down to Weight. Here we get a surprise and a big reason to depend on Morningstar. Fully one-third of VB’s holdings are classified as midcap stocks!

What might be going on? Well, Morningstar may set a higher bar for inclusion in the small cap space than VB’s underlying index. And this difference in criterion could exert a significant effect on performance. Readers may recall that VB’s average annual 10-year return was about 1% higher than that of similar funds. Could VB’s  portfolio have benefited from the higher long-term performance of midcap stocks?

Quite possibly. The iShares Russell 2000 ETF (IWM), which is curiously more popular than VB despite its higher expenses (.19 vs. .05), is virtually 100% small cap and did not enjoy a midcap edge. Likewise, iShares S&P Mid-Cap ETF advanced yet another percentage point more than VB. You will probably get the superior performance of VB only as long as midcap stocks continue to outperform.

We also see that VB is suitably balanced across the value vs. growth dimension. But if you want to more efficiently participate in a small cap revival and are not put off by the added cost, you might prefer the iShares offering (IWM).

Now, let’s scroll down to the Factor Profile. I want to point out the low quality of stocks in VB (and IWM). Small companies are more likely than large ones to have no earnings and balance sheets vulnerable to economic conditions. At Style Measures, you learn that the price/earnings ratio of VB is only 14, strikingly lower than the S&P’s 21 and reflecting the extent to which small stocks are currently out of favor.

The dividend, as expected, is nominal.  The Exposure table reveals another valuable piece of information—technology stocks represent only 15% of VB, less than half their weight in the S&P 500. Despite any qualms about investing in small caps, keep in mind you would gain substantial diversification away from the possibly overvalued technology sector.

With over 1,400 stocks that fully replicate its index and only 4% of the portfolio in its top 10 holdings, VB is more than amply diversified. You can see that turnover is only 12%, which speaks to the fund’s efficiency.

What about the actual holdings? Well, remember we’re dealing with small companies, so don’t despair if you only recognize a handful of names, like Williams-Sonoma and Texas Roadhouse. Take solace that VB’s constituent stocks are not closely followed by analysts.

Folks, now you’re armed to consider how well VB (or any other fund) fits into your investment plan. I hope you feel more confident about navigating Morningstar’s fund Portfolio page the next time you’re in a quandary.