ETF Talk: Look Small, Think Big

I’m sure you’ve heard the idiom, “big things come in small packages.” Well, this can certainly ring true when it comes to exchange-traded funds (ETFs).

As I noted last week, while the small-cap sector has not met early-year performance expectations, the likelihood of the Fed lowering interest rates later this year means those stocks may outperform by year-end. And with small caps selling cheaply on a price-to-earnings (P/E) basis, there could be a lot to gain in small-cap ETFs. As they say, size isn’t everything.

Now, dear readers, as you likely know, the ETFs I typically recommend here are passively managed, with the goal of tracking a given benchmark index.

This week, however, I’ll be introducing you to an actively managed fund, which has the goal of beating, rather than just tracking, its chosen index. And with potential slowing in the markets due to the Fed’s pause of this year’s anticipated rate cuts, I like the fund’s stated ambition to beat the market.

If you’re looking to the small-cap sector for a big boost, look no further than Avantis US Small Cap Value ETF (NYSEArca: AVUV).

This actively managed fund seeks long-term capital appreciation by picking U.S. small-cap value stocks that management believes are undervalued and highly profitable. Fund managers use a proprietary approach to choose small-cap stocks with high ratios of adjusted cash from operations to book value. Managers overweight the portfolio by using stocks with high profitability and value characteristics to get the best return.

The fund’s benchmark is the Russell 2000 Value Index, and AVUV has been crushing it consistently. AVUV’s one-year annual average return was a whopping 9.22% higher than its benchmark. The fund’s three-year average return also beat the benchmark soundly. Talk about packing a punch.

As of March 31, 2024, the fund has 775 holdings, which smooths any potential volatility from value traps. AVUV’s largest sector weightings are in financials, 27%; consumer discretionary, 19%; industrials, 18% and energy, 16%, with smaller weightings across several other sectors.

So, is there a catch? Remember that small-cap performance is sensitive to shifting interest rates. The Fed has already stated it has no intention of hiking rates this year, which could be a boon to small-cap value stocks. And value stocks tend to outperform during economic downturns or periods of slow growth. That means that if the economy weakens in 2024, small-cap value ETFs may flourish.

And with the wind coming out of the sails in some of the large-cap tech stocks that have been driving the market, there is some possibility of a slowdown this year.

Underperformance in large-caps and hints of weakness in the market mean a positive environment for small-cap value ETF investing.

Even if the best parameters for small-cap success don’t coalesce, recall that AVUV is an active fund. As such, its managers can be responsive to changes in interest rates and market conditions, though AVUV’s portfolio has downplayed sectors like health care that are more susceptible to such changes. This accounts for its excellent stability and performance.

The fund has net assets of $10.65 billion, an expense ratio of 0.25% (low for an actively managed fund) and a dividend yield of 1.67%. The fund is down 5.76% for the last month, up 1.67% for the past three months and down 1.21% year to date.

Chart Courtesy of StockCharts.com.

If you’re looking for high growth potential and exposure to undervalued companies, AVUV has a stellar performance history and packs huge potential for small-cap value investors going forward.

Be aware, however, that small-cap value investing poses higher risk and volatility compared to investing in larger, more established companies. Investors should always do their due diligence before adding any stock, mutual fund or ETF to their holdings.

As always, I am happy to answer any of your questions about ETFs, so do not hesitate to send me an email. You just may see your question answered in a future ETF Talk.