Vanguard Small Cap ETF: It’s Now Or Never

ETFS

At least for the past three years, if not longer, many experts have been betting on the resurgence of small-cap stocks. Barron’s even called 2017 “the year of the small cap”. So far, and apart from a few head fakes, these hopes have been crushed by continued underperformance relative to large cap (more on this below).

However, as I have suggested recently, this may finally be the time for small cap to shine. Not only does the current economic cycle seem to line up with the type of environment in which small cap would thrive, but the valuation gap between small and large cap stocks has rarely been this large.

Today, I look at the Vanguard Small Cap ETF (VB) as a potential instrument to take advantage of the shifting tide – if one indeed ends up happening sometime soon.

white open signage

Credit: Tim Mossholder

A word on the ETF

Before getting into the “why” of being long small cap stock, it helps to look more closely at the Vanguard Small Cap ETF. This popular fund, which has $90 billion in assets under management, trades an average daily volume of around $100 million, according to Yahoo Finance. Even better than high liquidity, VB charges a management fee of only five bps per year – i.e. 0.05%.

Compared to an index like the S&P 500 (SPY), which is heavily allocated to the tech sector, VB is much more diversified. The fund’s exposure to a single sector does not exceed 19%, as the pie chart below depicts. Also, the top ten holdings in the fund, most of which unknown to most investors, account for only 3.9% of the total assets. This figure is much lower than the S&P 500’s 28% concentration in the top ten stocks.

Source: DM Martins Research, data from Vanguard

Why small cap could outperform

Let me address my two bullish arguments one at a time.

First, small-cap stocks have historically performed better during periods of economic recovery and early enough through cycles of stability. The chart below, spanning about 50 years, helps to illustrate the point – the blue line is small cap, while the red line is large cap.

Notice that small cap tends to pull away from large cap after crises like the early-to-mid 1970s oil embargo and the dot-com bubble burst. Lately, due in great part to the COVID-19 pandemic of 2020 and ensuing recession, small cap has fallen out of favor once again, with a rebound yet to be witnessed.

A discussion could be had about whether we are about to enter a period of economic recovery. Signs have been mixed: a rebound in GDP and falling unemployment contrast with expectations for rising bankruptcies, for example. The short-term prospects are not all that reassuring, considering lack of additional fiscal stimulus and a US government that could be split between Democrats and Republicans across the White House and the Senate.

But thinking a bit more long term, it is a bit easier to make an argument that 2020 will probably have marked a low in economic activity. From here, and given enough time, things are likely to get better rather than worse – even if the path forward is winding in the foreseeable future.

Source: graph by Portfolio Visualizer

The second bullish argument is closely related to the first, but has more to do with valuation. Rather than looking at P/E or other multiples, let’s keep it simple. The chart below depicts a hypothetical portfolio that is long large cap, short small cap stocks. The funds that I used in this exercise, due to their longevity, are the Vanguard 500 Index Fund Investor Shares (VFINX) and the Vanguard Small Capitalization Index Fund Investor Shares (NAESX).

Notice that large cap reached a relative high compared to small cap just as the Great Recession of 2008 began to unfold. As early as March 2009, small cap began to regain ground. Despite a hiccup in 2011 that coincided with the European debt crisis, the trend persisted through early 2014, which could be interpreted as the point at which small cap became overvalued. Since then, large cap recovered progressively and is now valued relative to small cap at roughly the same 2008 peak levels.

Source: graph by Portfolio Visualizer

Something very similar happened in the previous economic cycle. During the 1990-1991 recession, small cap began to outperform large cap. The trend carried through the middle of the expansionary phase, peaking in 1994. Between then and five years later, large cap took over.

Large cap’s valuation peak in 1999 was probably exaggerated by the dot-com bubble distortions. But like clockwork, that same year, small cap began to outperform, as the 2001 recession ran its course.

Source: graph by Portfolio Visualizer

Last few words

Of course, the trends of the past three decades do not ensure that something similar will happen going forward. But if I were to assign probabilities (and how else can I make investment decisions, since I cannot accurately predict the future?), I believe the odds of small cap outperforming large cap in the next three to five years to be very significant. At the very least, I cannot think of a better time for small cap’s outperformance to kick in than right around now (i.e. 2020-2021).

A smarter portfolio

“Thinking outside the box” is what I try to do everyday alongside my Storm-Resistant Growth (or SRG) premium community on Seeking Alpha. Since 2017, I have been working diligently to generate market-like returns with lower risk through multi-asset class diversification. The results have been impressive.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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