One of the most common criticisms of smart beta strategies, including exchange traded funds (ETFs), is that there are two primary reasons why fundamentally-weighted benchmarks and funds outperform their cap-weighted counterparts. Those reasons are the size and value factors. What that means is that, over time, smaller stocks typically outperform large-caps. Historical data confirm as much. Likewise, while the value factor has been known to struggle against growth and momentum, the long-term performance of value against other investment factors is generally impressive. In 2017, for instance, the MSCI USA Value Index rose by nearly 22%.
The criticism of smart beta strategies being dependent on the size or value factors misses the mark because many smart beta ETFs emphasize neither of those factors. However, the critique does remind investors about the efficacy of small-cap value funds. Small-cap value stocks are those companies that meet the market capitalization definition of small-cap while trading at prices below their book values, a trait that implies value. The Fama/French three factor model recognizes the size and value factors as the two most potent of the model's factors. Given that the MSCI USA Small Cap Index returned more than 17% last year, one could argue that this still holds true.
Year-to-date, the S&P SmallCap 600 Index has actually fallen by just under 2%. However, since the December 31, 2015, the Index has climbed by almost 388%. “Among small-cap U.S. equity, the value premium over the 26-year period (1990-2015) was an astonishing 187 basis points (bps); that is, a 26-year value return of 10.19 percent minus a 26-year growth return of 8.32 percent equals a value premium of 187 bps. With a 26-year annualized return of 10.19 percent, small-cap value turned $10,000 into $124,669, or $44,791 more than the ending balance in small-cap growth,” according to Fidelity research.
In recent months, though, a decline in small-cap prices may have discouraged investors from adopting this approach. Investors can expand the smart beta strategy to small-cap value by considering multi-factor ETFs such as the JPMorgan Diversified Return U.S. Small Cap Equity ETF (JPSE). Obviously, JPSE is a small-cap fund, so the size factor is taken care of, but the ETF emphasizes other factors, including momentum, quality and value. This helps to mitigate any potential losses to the small-cap area.
The approach is working. Year-to-date, JPSE is up 3.33%, an advantage of more than 500 basis points over the S&P SmallCap 600 Index. The ETF's multi-factor approach is bearing fruit. After all, U.S. small-caps are lagging large-caps and the value factor is trailing other factors, indicating JPSE's integration of quality and momentum into the small-cap value equation is compelling for long-term investors.