VBR - VBR's Underperformance Explained

2023-09-18 14:43:32 ET

Summary

• VBR is a simple U.S. small-cap value index fund.
• VBR has underperformed YTD, as have most other small-cap value funds.
• An explanation of why follows.

I've written about several small-cap value equity index funds in the recent past . I've generally been bullish, on valuation grounds. Small-cap value been underperforming since, with the benchmark Vanguard Small-Cap Value Index Fund ( VBR ) lagging behind the S&P 500 by over 10% YTD. VBR has underperformed by a bit more since my last coverage as well.

Considering the above, I thought a quick article analyzing, and explaining, VBR's underperformance was in order.

VBR's recent underperformance was almost entirely due to an overweight position in the worst-performing area (regional banks), and an underweight position in the best-performing area (tech stocks). Valuations and earnings growth seem to have played a much more minor, uncertain, role. As fund fundamentals remain strong, and as the regional banking crisis has abated, I don't believe that recent fund weakness is a deal-breaker, nor indicative of future underperformance. As such, I remain bullish on the fund.

Small-Cap Underperformance Explained

Overweight Worst-Performing Financials

VBR is significantly overweight financials relative to most other broad-based U.S. equity indexes, as is the case for most small-cap value equity funds. Compare VBR's industry exposures to those of the S&P 500.

VBR's overweight financials position is due to the plethora of publicly-traded regional banks and small investment management firms in the United States. Some of the fund's larger holdings in this space are First Citizens ( FCNCA ), a regional bank focused on the Carolinas, and New York Community Bancorp ( NYCB ), focused on New York.

As should be clear from the above, VBR's overweight financials position is, in a sense, an overweight regional banks position. Regional banks have performed terribly YTD , as higher interest rates led to lower bond prices , causing significant losses to many banks. VBR is overweight these underperforming banks, which explains a sizable portion of the fund's underperformance. The fund was actually outperforming before the crisis hit. The graph is striking.

VBR's overweight financials position was responsible for a significant portion of its recent underperformance. Although exact figures are impossible to calculate, it seems this issue was responsible for slightly over half of the fund's underperformance, or around 6.0%. I get this from assuming a 15% regional bank allocation, and with said industry underperforming by 40%. VBW's financials allocation is higher, but said position does not only include regional banks, and the S&P 500 includes some regional banks too.

Underweight Best-Performing Tech

VBR is significantly underweight tech relative to most other broad-based U.S. equity indexes, as is the case for most small-cap value equity funds. Compare VBR's industry exposures to those of the S&P 500.

As can be seen above, VBR is more than 20% underweight tech, a significant difference vis-a-vis the S&P 500. This is almost entirely due to the great number, and size, of mega-cap tech stocks. Tech companies like Apple ( AAPL ) and Microsoft ( MSFT ) are gigantic , and so dominate market-cap weighted indexes like the S&P 500. Small-cap, market-cap weighted equity indexes like VBR can't really be dominated by a couple of names so easily, as they only invest in comparatively small companies.

VBR's underweight tech position has led to some underperformance in the past, as tech has performed exceedingly well YTD.

From the above, it seems that VBR's underweight tech position led to slightly under half of the fund's underperformance, or around 4.0%. This is from a 20% overweight position, times 20% underperformance.

It seems that VBR's financials and tech position accounted for more or less the entirety of its underperformance. A quick look at some other potential factors seems to confirm this.

Slightly Wider Valuation Gaps

Small-cap equities tend to trade with discount valuations, due to greater (perceptions of) risk. Small-cap value equities doubly so, for obvious reasons. VBR itself currently trades with a 11.7x PE ratio, and a 1.8x PB ratios. Both figures are quite low on an absolute basis, and around half those of the S&P 500. There is a similar valuation gap vis-a-vis all-cap equity indexes, narrower ones versus broader small-cap equity indexes.

VBR's valuation has become a bit pricier these past few months, due to a rising share price and weak financial earnings. Importantly, most U.S. equity indexes have become a bit pricier too, mostly due to higher share prices. A quick look at how equity index valuations have evolved these past few months.

Doing some math on the above, it does seem like VBR's valuation rose by a bit less than average, becoming even cheaper vis-a-vis its peers than before. Nevertheless, these are somewhat volatile figures, and as all relevant broad-based equity indexes have become more expensive YTD, I'm not sure that changes in valuations are able to explain VBR's underperformance.

Reasonable Earnings Growth

Although I'm lacking explicit, hard data, it seems like VBR's earnings have grown at a reasonable pace these past few months. Morningstar seems to think so too, although I'm unsure about their time frames.

Looking at industry earnings, growth seems to have been reasonable, too. Energy and materials have seen declining earnings, and the fund is somewhat overweight these two industries, but not significantly so. Tech saw declining earnings in prior months too, although growth has picked up as of late.

Even regional banks have seen positive earnings growth in the recent past, excluding the bankrupt ones at least.

It does not seem like declining or weaker-than-expected earnings growth have played a role in VBR's underperformance, although the data I have is not terribly specific.

Conclusion

VBR's recent underperformance was almost entirely due to an overweight position in poor-performing regional banks, and an underweight position in top-performing tech stocks. As fund fundamentals remain strong, and as the regional banking crisis has abated, I remain bullish on VBR long-term.

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