VTWO: Highly Diversified Portfolio Of Small Caps Fails To Generate Lucrative Return

~ by Snehasish Chaudhuri, MBA (Finance)

Vanguard Russell 2000 ETF (NASDAQ:VTWO) is an exchange-traded fund that invests in growth and value stocks of small-cap companies. It invests in a large pool of stocks operating across diversified sectors. This often-overlooked asset class has the potential of generating strong capital growth because these firms are also strong acquisition targets. Small-cap stocks by their very nature are a little bit riskier than their large-cap peers. This fund generates low yield and total return is quite average around 7 to 8 percent. However, total return has been strong during the high-growth period between 2016 and 2021. The fund generated an annual average total return of 14.3 percent during that time. However, there is some concern about the future price performance of this fund, as small-cap funds may not witness any growth if there is a recession.

VTWO Invests a Small Proportion of Its Assets in a Large Pool of Small Caps

Vanguard Russell 2000 ETF was launched and is managed by The Vanguard Group, Inc. It seeks to track the performance of the Vanguard Russell 2000 Index which is designed to measure the performance of small-cap stocks listed in the equity markets of the United States. VTWO replicates the Russell 2000 Index by investing all of its assets in the stocks in the same proportion in which it makes up the index. The fund invests in a large pool (more than 2000) of stocks, and thus a very small portion of its assets is invested in a particular stock. Top 10 holdings account for less than 3 percent of its entire portfolio.

In Absence of Strong Yield, VTWO Became Unattractive After Its Recent Price Rally

Vanguard Russell 2000 ETF was formed on September 20, 2010, and has been offering consistent quarterly pay-outs since the 3rd quarter of 2015. However, annual Vanguard Russell 2000 Index Fund ETF Shares (VTWO) Dividend Yield has been considerably low within the range of 1 to 1.5 percent. Almost two-third of its $6.24 billion AUM is invested in five sectors - financial, healthcare, industrial, consumer discretionary, information & communication technology (ICT). I believe these sectors have high growth prospects in the coming decade. VTWO also has a very low expense ratio of 0.1 percent, which makes diversified investments easier in funds involving only small-cap stocks.

As the economy starts recovering and the corporate earnings are largely constructive, it all comes down to VTWO's capacity to recover its earnings power, and the speed with which it is able to do so. But after its recent rally (a price growth of 7 percent in 2023), VTWO's portfolio becomes unattractive. Thus, VTWO’s price rally seems to have run out of steam. In a nutshell, despite having decent growth potential, the fund is not an attractive investment option.

Investability of VTWO according to My "7 Factor Model for Evaluating Global Funds"

VTWO’s long-term yields are lower than the current rate of inflation. Vanguard Russell 2000 ETF offers high potential for investment growth; share value typically rises and falls more sharply than that of funds holding bonds. VTWO's upside potential is modest, which is not good enough to justify buying fresh units of this fund at its current valuation. I would like to find out VTWO’s investability by applying my "7 Factor Model for Evaluating Diversified Funds."

Through "7 Factor Model for Evaluating Equity Funds," I try to assess whether the fund qualifies with respect to some basic criteria such as assets under management of $200 million, yield of 4 percent, current market price of $5, and diversification of its investments among eight major sectors - technology, financial, healthcare, industrial, energy & materials, real estate, consumer products and utilities. Degree of discount from its current net asset value, risk of its current portfolio, and sustainability of its current yield are the remaining 3 factors that ultimately helps me to assess the attractiveness of Vanguard Russell 2000 ETF for both its income-seeking and growth-seeking investors.

Investment Thesis

I find Vanguard Russell 2000 ETF is not an attractive fund according to my "7 Factor Model for Evaluating Diversified Funds." It qualifies for the minimum requirements with respect to AUM of $200 million, stock price of $5, and has a decent overall return of around 7 percent over the longer term. During the 5-year period between 2016 and 2021, the annual average total return was more than 14 percent. It has a very low expense ratio, which enables investors to benefit from a highly diversified portfolio. The portfolio is well-diversified and carries a relatively low level of risk. VTWO invests the majority of its assets in four sectors (ICT, financial, technology, industrial) that have high-growth potential.

However, there is some concern about the future price performance of this fund, as small-cap funds may not witness any growth if there is a global recession. Small-cap stocks usually are traded less than their large-cap peers. There is also the possibility of these small caps not generating significant returns over the long run. A low turnover ratio of 19 percent also doesn’t provide much scope for an overhaul of its portfolio. Moreover, the fund generates a very low yield around 1.2 percent. In the absence of price growth, VTWO’s yield will not be sufficient enough to beat even the current level of inflation. It is also currently trading at par with its net asset value of $75.05. Thus, I would suggest a hold for the investors of Vanguard Russell 2000 ETF.

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