Small Cap Blend Style

The Small Cap Blend style ranks eleventh out of the twelve fund styles as detailed in my Style Rankings for ETFs and Mutual Funds report. It gets my Dangerous rating, which is based on aggregation of ratings of 24 ETFs and 644 mutual funds in the Small Cap Blend style as of April 22, 2014. Prior reports on the best & worst ETFs and mutual funds in every sector and style are here.

Figures 1 and 2 show the five best and worst-rated ETFs and mutual funds in the style. Not all Small Cap Blend style ETFs and mutual funds are created the same. The number of holdings varies widely (from 24 to 2512), which creates drastically different investment implications and ratings. The best ETFs and mutual funds allocate more value to Attractive-or-better-rated stocks than the worst, which allocate too much value to Neutral-or-worse-rated stocks.

To identify the best and avoid the worst ETFs and mutual funds within the Small Cap Blend style, investors need a predictive rating based on (1) stocks ratings of the holdings and (2) the all-in expenses of each ETF and mutual fund. Investors need not rely on backward-looking ratings. My fund rating methodology is detailed here.

Investors should not buy any Small Cap Blend ETFs or mutual funds because none get an Attractive-or-better rating. If you must have exposure to this style, you should buy a basket of Attractive-or-better rated stocks and avoid paying undeserved fund fees. Active management has a long history of not paying off.

Get my ratings on all ETFs and mutual funds in this style by searching for Small Cap Blend on my mutual fund and ETF screener. For more products, click here.

* Best ETFs exclude ETFs with TNAs less than $100 million for inadequate liquidity.

Click here to see the five ETFs that are excluded from Figure 1 because their total net assets (TNA) are below $100 million and do not meet our liquidity standards.

* Best mutual funds exclude funds with TNAs less than $100 million for inadequate liquidity.

Boston Trust & Walden Funds: Walden Mid Cap Fund (WAMFX) and Quaker Investment Trust: Quaker Small-Cap Value Fund (QSVIX) are excluded from Figure 2 because their total net assets (TNA) are below $100 million and do not meet our liquidity standards.

State Street SPDR Russell 2000 Low Volatility ETF (SMLV) is my top-rated Small Cap Blend ETF and Virtus Equity Trust: Virtus Quality Small-Cap Fund (PXQSX) is my top-rated Small Cap Blend mutual fund. SMLV earns my Dangerous rating and PXQSX earns my Very Dangerous rating.

iShares Micro-Cap ETF ( IWC) is my worst-rated Small Cap Blend ETF and Pacific Advisors Fund Inc: Small Cap Value Fund (PASMX) is my worst-rated Small Cap Blend mutual fund. IWC earns my Dangerous rating and PASMX earns my Very Dangerous rating.

Figure 3 shows that 243 out of the 2615 stocks (over 8% of the market value) in Small Cap Blend ETFs and mutual funds get an Attractive-or-better rating. However, 0 out of 24 Small Cap Blend ETFs and 0 out of 644 Small Cap Blend mutual funds get an Attractive-or-better rating.

The takeaways are: mutual fund managers allocate too much capital to low-quality stocks and Small Cap Blend ETFs hold poor quality stocks.

Sources: New Constructs, LLC and company filings

As detailed in “Low-Cost Funds Dupe Investors”, the fund industry offers many cheap funds but very few funds with high-quality stocks, or with what I call good portfolio management.

Investors need to tread carefully when considering Small Cap Blend ETFs and mutual funds, as no ETFs or mutual funds in the Small Cap Blend style allocate enough value to Attractive-or-better-rated stocks to earn an Attractive rating. Investors looking for exposure to this investment style would be better suited with individual stocks.

Syntel Inc. (SYNT) is one of my favorite stocks held by Small Cap Blend ETFs and mutual funds and earns my Very Attractive rating. SYNT has grown after-tax profits (NOPAT) by 19% compounded annually over the past decade, including 22% growth last year. This solid growth has helped SYNT earn a top quintile return on invested capital (ROIC) of 54%. Despite its impressive growth, the stock remains cheap. At its current price of ~$80/share, SYNT has a price to economic book value (PEBV) ratio of 1.2. This ratio implies the market expects SYNT to grow NOPAT by no more than 20% for the remaining life of the company. Given the fact that SYNT has grown NOPAT by nearly 20% a year for the past decade, such a low expectation seems unwarranted.

Swift Transportation (SWFT) is one of my least favorite stocks held by Small Cap Blend ETFs and mutual funds and earns my Very Dangerous rating. SWFT has seen fairly stagnant profits since its IPO in 2010, as NOPAT has grown by just 4% compounded annually, and ROIC has held steady at 8.5%. Despite this lack of growth, the stock is up almost 130% since the IPO. This disconnect between the stagnant profits and the surging stock has led to SWFT being significantly overvalued. In order to justify its current valuation of ~$25/share, SWFT would need to grow NOPAT by 15% compounded annually for 23 years. There is nothing in SWFT’s track record to suggest that it’s capable of that kind of long-term profit growth.

Figures 4 and 5 show the rating landscape of all Small Cap Blend ETFs and mutual funds.

My Style Rankings for ETFs and Mutual Funds report ranks all styles and highlights those that offer the best investments.

Review my full list of ratings and rankings along with reports on all 24 ETFs and 644 mutual funds in the Small Cap Blend style.

To protect your portfolio from the worst ETFs and mutual funds, click here for a free trial.

Kyle Guske II contributed to this report.

Disclosure: David Trainer owns SYNT. David Trainer and Kyle Guske II receive no compensation to write about any specific stock, sector, style or theme.