SPSM - VB: Changing My Mind On Vanguard's Small-Cap ETF

2023-07-16 19:43:38 ET

Summary

• I decided to sell the VB ETF fund due to its underperformance compared to the S&P 500 and Invesco Nasdaq-100 Trust.
• Despite its low expense ratio and solid 10-year average annual return, the VB ETF's increased diversification has not resulted in increased short-, medium-, or long-term returns.
• The VB ETF's over-weighting in the industrial and consumer discretionary sectors may not prove advantageous in the long run due to its under-weighting in the technology sector.

Back in September of 2021, Seeking Alpha published my article The Vanguard Small-Cap ETF: A Great Way To Diversify Your Mega-Cap Portfolio . Since that time, large-cap technology stocks have helped the S&P 500 outperform the small-cap focused ( VB ) ETF by ~9%. Further, and as the chart below clearly shows, on a longer-term basis the returns of the Vanguard S&P 500 ETF ( VOO ) have been superior to VB.

As a result, and in my quest to simplify my portfolio by reducing equities that don't offer significant return and/or diversification advantages, I have decided to sell the fund and - over time - move the proceeds into existing positions in VOO and the Invesco Nasdaq-100 Trust ( QQQ ).

Other Considerations

That said, many investors might still consider the VB ETF to be an attractive holding for its relatively low expense ratio (0.05%, only 2 basis points higher than VOO's fee) and its solid 10-year average annual return (9.46%).

In addition, and somewhat surprising to me, is that both the VB and VOO ETFs have roughly the same yield (~1.5%), but the VB ETF's three-year dividend CAGR is actually significantly higher than that of the S&P 500:

Meantime, the VB ETF is much (much) more diversified as compared to the S&P 500 VOO ETF, holding almost 3x the number of total companies (1,459) and with the top-10 holdings having only a 3.5% allocation as compared to 30.4% for the S&P 500's top-10 components. However, as mentioned earlier, if that increased diversification doesn't come with increased short, medium, or long-term returns, what is the point?

Indeed, while the chart above clearly shows that VB had a strong showing vs. the S&P 500 from the fall of 2020 to the fall of 2021, it suffered greatly during last-year's severe bear market and VOO has begun, once again, to outperform.

Portfolio

The top-10 holdings in the VB ETF are shown below and were taken directly from the Vanguard VB ETF homepage , where investors can find more detailed information on the fund:

My followers know that, at this point in my ETF articles, I will typically run though descriptions of a few of the top-10 holdings. However, given that the VB ETF holds 1,459 companies, no one company - no matter how good (or how bad ...) - can significantly move the fund's NAV given that all of the top-10 holdings have less than a 0.4% allocation, and that level declines rather rapidly as one goes down the list of the 1,459 holdings.

As a result, arguably more important than the individual holdings in the VB ETF, is the fund's allocation across sectors and its differentiation as compared to the S&P500 (added in red by the author):

As can be seen in the graphic, VB's largest allocation is to the industrial sector (21.6%) - which is more than 2.5x that of the S&P 500. That may be attractive given the Biden administration's ability to pass a comprehensive and long-term infrastructure investment bill. The Consumer Discretionary sector also has significantly higher allocation in the VB ETF as compared to the S&P 500 (50% more), which may bode well for the fund on a pickup in the overall consumer-led economy. That said, I'm not convinced that either one of these sector over-weights will prove advantageous - over the long run - given the relatively significant under-weighting of the Technology Sector, arguably the most vibrant of all sectors, as compared to the S&P500.

Performance

However, as stated previously, the VB ETF does have a relatively solid long-term performance track-record:

That said, the VOO ETF's 10-year average annual return is 12.8%. So, once again, what's the point of the supposed diversification benefit of the VB small-cap ETF if the long-term returns are significantly lower than the plain-old S&P 500?

The following graphic compares the five-year total returns of the VB ETF with some of its small-cap competitors - the Schwab US Small-Cap ETF (SCHA), the SPDR Portfolio S&P 600 Small Cap ETF ( SPSM ), and the iShares Core S&P Small-Cap ETF ( IJR ) - along with that of the S&P 500 as represented by the VOO ETF:

While the VB ETF compares quite favorably against its direct competitors, again, the fund's returns (and that of its small-cap oriented peers) significantly lag that of the S&P500.

Summary and Conclusion

As my followers are likely aware, several years ago I began an effort to simplify my portfolio by reducing the number of its overall holdings. It has been a successful endeavor that has led to a portfolio that is easier to track and analyze, and my returns have increased as well (versus the S&P500, which is the benchmark I use to measure my portfolio's performance).

Prior to this portfolio simplification effort, I had added the VB ETF to help diversify my portfolio - a portfolio that was significantly over-weight both large-cap technology and energy stocks. The problem is the fund has under-performed and has detracted from my overall returns. As a result, I plan to sell the VB ETF this week and move the proceeds (over time) into existing positions the VOO and QQQ ETFs.

I'll end with a three-year comparison of the VB ETF to VOO and QQQ:

For further details see: