VXF - VXF: A Mid And Small-Cap Blend ETF For Mid-Term Gains?

2023-03-26 03:21:49 ET

Summary

• Vanguard's Extended Market ETF tracks the performance of the mid & small-cap equities space.
• VXF has recorded a -18.27% TTM return underperforming the broader market.
• Mid and small-caps are undervalued compared to 20-year average multiples and more likely to outperform going forward.
• Risk-return metrics for the fund give mixed signals relative to its counterparts.

Thesis

Mid & small cap investing has somewhat fallen out of style as most passive investors receive market returns through an S&P 500 fund and technology mega-caps occupy most attention and dominate the financial news cycle. Yet, for the investor looking to gain some exposure in smaller equities Vanguard offers a rather interesting ETF choice, its Extended Market ETF ( VXF) which tracks the performance of the mid & small-cap space. In this analysis, I go over a brief overview of the fund, explore its mid-term outlook and run a backtest on its relative risk & return performance.

Over the past year, VXF has been on a steep downward path with elevated volatility, as the broader market experiences significant turmoil. VXF has recorded a -18.27% TTM return underperforming the broader market.

Fund Overview

VXF is dedicated to tracking the performance of an extended range of small and mid-cap stocks. It charges a very low, 0.06% expense ratio and has Assets Under Management of Approximately $13.4B. VXF invests in U.S stocks and also pays a 1.15% dividend yield. Invested in over 3,600 companies, the fund's median market cap stands at $6.1B, which is geared more towards the mid-cap space.

VXF is relatively well-diversified across different sectors. Technology, Industrials and Financials occupy the largest exposure within the ETF, at 18.9%, 16.4% and 16.1% respectively. The Healthcare and Consumer Discretionary sectors also maintain significant weightings. Compared to a large-cap or an S&P 500 ETF, the technology sector holds a smaller weighting in VXF.

In addition to being well-diversified across sectors, VXF also exhibits little concentration, with its top ten holdings accounting for just 7.3% of total weighting. That is compared to the S&P 500, where the 10 largest stocks account for over 25% of the index weight. Some of VXF's largest holdings include companies like Uber Technologies, Blackstone, Square, Lululemon, Marvell Technology and others.

Low concentration and greater sector diversification are, in my view, key attributes of a fund with exposure to smaller firms in order to somewhat mitigate the higher risk the space brings to a portfolio.

Small & Mid-Caps to Outperform?

Over the past 10 years, both small and mid-cap equities have underperformed their large-cap counterparts. Technology giants and consumer discretionary conglomerates have led a multi-year rally that was briefly interrupted by the global Covid-19 pandemic and as of recently has been challenged by defiant macroeconomic challenges.

While for many years investors and analysts alike viewed size as the enemy of performance, the past decade has proven otherwise. More specifically, according to J.P. Morgan's analysis, available in the table below, 10-year annualized returns for large caps stand at 12.6% (blend style) while mid and small caps have returned 11.0% and 9.0% respectively. This lag in performance is also evident in the value and growth factors. 2022 has also followed on the same path, as small caps exhibited the largest drawdown (-20.4% for the year).

Even though some will assume that the market has systemically changed and maybe even choose to rotate away from mid & small-cap equities, it is important to note that history shows that, more often than not, trends revert back to their mean, therefore any observable deviation from them in the short-run can be exploited for gains.

That might be the case across different size equities today. Mid and small-caps are undervalued compared to 20-year average multiples and are more likely to outperform going forward. For instance, the average P/E for mid-caps over the past 20 years is 16.3x, compared to their current 15.3x multiple. The same is true for small caps (21.3x 20-year average vs. 19.1x current P/E multiple) and especially when it comes to the value factor. Conversely, large-caps appear overvalued coming into 2023 and therefore more likely to underperform in the short-term relative to their smaller counterparts.

Backtesting Performance

In order to gauge the performance attributes of VXF in comparison to the S&P 500 and also some closely related Vanguard funds, I employed the tools offered by Portfolio visualizer. I ran a backtest for each of the four ETFs mentioned below over an 18+ year period, going back to 2004, when the oldest data for all four ETFs are available. The funds analyzed together with VXF are SPDR's S&P 500 ETF ( SPY ), Vanguard's Mid Cap ETF ( VO ) and Vanguard's Small Cap ETF ( VB ). Dividend reinvesting is assumed for the backtest.

As shown in the chart provided below, Vanguard's mid-cap ETF has recorded the greatest performance over the reference period, with VB and then VXF following. It also becomes visible in the chart, that all three smaller equity ETFs have performed very well over an extended period of time despite the mid & small-cap space lagging the broader market in performance. This points to superior index selection by Vanguard for all three ETFs as well as strong and strategic index composition.

Diving into more risk-return detail for the ETFs, a $10,000 initial investment in VHF in 2024 would have yielded $51,057 today (8.92% CAGR), compared to SPY yielding $50,459 over the same period of time (8.85% CAGR). Vanguard's Mid-cap ETF brought the highest returns, with a 9.53% CAGR.

In terms of risk, VXF displays the second-largest standard deviation, at 19.02%, behind Vanguard's small-cap fund. It also carries the lowest Sharpe and Sortino ratios. It should be noted, however, that all three Vanguard ETFs fall behind the S&P in terms of risk-adjusted performance, as it should be expected given the elevated risk profile of the mid & small-cap space and the relatively stronger performance of large caps over the last decade, analyzed in a previous section. Vanguard's mid-cap ETF records the largest drawdown of -54.01%, while VXF comes second in terms of its best-year performance of 38.26%.

Final Thoughts

The quality of the VHF ETF is unquestionable, and the fund should yield superior returns in the case that the mid & small-cap space catches up on historical average valuation multiples and appreciates relative to the broader market. However, as the simulation provided in the previous section showed, both Vanguard's VB and VO also offer attractive attributes and strong performance records. Overall, I would rate VXF as a buy.

For further details see: