Does Your Portfolio Need a Small-Value Fund?

Small-cap value funds can sometimes be a difficult space for investors to successfully navigate for various reasons. Compared with large-cap funds, small-cap funds pose several challenges, including higher volatility and potential liquidity troubles. For the five years ended May 2024, small-cap stocks significantly underperformed large caps, according to the Morningstar Style Box.

That said, small-cap value stocks’ relatively more moderate price multiples can lead to lower downside risk compared with high-priced growth names and can still be a valuable addition to a diversified portfolio. Over the five years ended in May, a correlation of 0.85 between the Russell 2000 Value Index and the S&P 500 suggests that having a small-value fund in a multi-asset portfolio added some diversification benefits.

Below are three funds that beat the majority of their small-value Morningstar Category peers on a risk-adjusted basis over the past decade.

DFA US Small Cap Value DFSVX, which holds a Morningstar Medalist Rating of Silver, takes a broadly diversified and cost-conscious approach. This fund is one of the most sprawling in the small-value category with more than 900 stocks. The portfolio managers consider the bottom 10% of US stocks by market cap, excluding companies working through bankruptcies. The managers exclude REITs, as they consider them to be a separate asset class, and utilities because of their limited upside. The team then considers stocks that land in the cheapest 35% of the small-cap market by price/book ratio. It avoids companies with unattractive expected returns based on low profitability and aggressive investment strategies. This fund’s performance relative to the Russell 2000 Value Index depends on how the smaller-cap stocks trading at lower valuations perform. In 2020, the strategy lagged during the coronavirus-driven selloff (Feb. 1 through March 31) and outperformed during the rebound (April 1 to Dec. 31)

Silver-rated AMG River Road Small Cap Value ARSVX plays defense. Seasoned comanagers Justin Akin and Andrew Beck lead this strategy with support from a solid team. The group conducts fundamental research in pursuit of companies with proficient management, strong financials, and a shareholder-centric approach. The team estimates a fair value for each security and likes those with low downside risk. Management uses a proprietary scorecard to quantify key components of its thesis, including its verdict around valuation assumption. The result is a high-conviction portfolio with roughly 50 to 70 securities. The valuation-led approach results in clear sector deviations from small-value peers and the category benchmark; the portfolio has consistently preferred more-stable industrial firms and invested relatively less in financial-services and biotech names. The portfolio captured less than 70% of the index’s returns during down markets and beat the average category peer and index in every market drawdown of 10% or more.

Bronze-rated Royce Small-Cap Total Return RYTRX has a new lead manager, but the team and approach remain compelling. Miles Lewis, who took over in May 2021, added more rigor to the approach through data, documentation, and formality. The team believes that dividend payers and companies that buy back their shares generally have competitive advantages, good management, and strong finances. The portfolio maintained at least 90% of its assets in dividend-paying stocks until mid-2022 when it started allowing up to 35% to be invested in companies that buy back stock or may pay dividends one day. Lewis’ research found that more small-cap companies have been repurchasing shares and fewer have been paying out dividends. Dividend-paying stocks still dominate the portfolio despite the change. However, the fund now owns 75 to 100 names, roughly half as many as it used to.

This article first appeared in the July 2024 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor by visiting this website.