VIOV's Underperformance in the Small-Cap Value Space: A Factor Purity and Portfolio Construction Analysis

The small-cap value segment of the market has long been a battleground for investors seeking exposure to undervalued, smaller companies. Yet, the Vanguard S&P Small-Cap 600 Value ETF (VIOV) has struggled to outperform its peers in recent years, despite its low expense ratio and broad market recognition. A closer examination of factor purity and portfolio construction reveals why VIOV lags behind alternatives like the Avantis U.S. Small Cap Value ETF (AVUV) and the Dimensional U.S. Targeted Value ETF (DFAT).

Factor Purity: The Achilles’ Heel of VIOV

Factor purity—the extent to which an ETF’s returns are attributable to specific risk premiums like Size and Value—is critical for long-term performance. VIOV, which tracks the S&P SmallCap 600 Value Index, is designed to capture these premiums but falls short compared to actively managed alternatives. According to a report by OptimizedPortfolio, AVUV delivers a 58% concentration in small-cap value stocks, significantly higher than VIOV’s roughly 45% [2]. This disparity stems from AVUV’s rigorous stock selection criteria, which prioritize the smallest and cheapest companies with strong fundamentals, whereas VIOV’s index-based approach includes mid-cap and “blend” stocks that dilute its value tilt [1].

Similarly, DFAT, another actively managed fund, achieves a 51% small-cap value concentration, outperforming VIOV but trailing AVUV [2]. These metrics underscore a key insight: passive strategies like VIOV, while cost-effective, often lack the precision of active managers who can filter out less pure value exposures.

Portfolio Turnover: Efficiency and Tax Implications

Portfolio turnover, a measure of how frequently assets are bought and sold, impacts both performance and tax efficiency. VIOV’s turnover rate is approximately 15 basis points, a figure that, while low, pales in comparison to AVUV’s 7% and DFAT’s 3% [2]. Lower turnover reduces transaction costs and capital gains distributions, making AVUV and DFAT more tax-efficient choices for taxable accounts. In contrast, VIOV’s higher turnover—coupled with its inclusion of mid-cap stocks—introduces unnecessary friction that erodes returns over time.

Vanguard’s VBR, another small-cap value ETF, exemplifies the pitfalls of high turnover. Despite its 0.07% expense ratio, VBR’s 16% turnover and 31% small-cap value concentration highlight its diluted focus [2]. This mid-cap bias, as noted by Bogleheads forum contributors, makes VBR a less effective vehicle for capturing the Size and Value premiums [1].

Stock Selection and Factor Loadings

The construction of a small-cap value ETF hinges on its ability to load onto key factors: Value (HmL), Size (SmB), and Profitability. AVUV’s methodology, which emphasizes low price-to-book ratios and high profitability, results in superior factor loadings compared to VIOV. Data from the OptimizedPortfolio analysis indicates that AVUV’s exposure to the Value factor is 1.2x that of VIOV, while its Profitability factor loading is 0.8x versus VIOV’s 0.5x [2]. These differences are not trivial; they directly influence returns during market cycles where value and profitability premiums are in play.

VIOV’s reliance on the S&P SmallCap 600 Value Index also limits its ability to adapt to changing market conditions. The index’s rules-based approach includes stocks that may no longer exhibit value characteristics, whereas active managers like AVUV can dynamically adjust holdings to maintain factor purity [1].

Cost vs. Performance Trade-offs

While VIOV’s 0.15% expense ratio is competitive, it fails to justify its underperformance relative to higher-cost peers. AVUV’s 0.25% fee is offset by its enhanced factor exposure and lower turnover, making it a more cost-effective choice for investors prioritizing long-term returns. As one investor noted on the Bogleheads forum, “The incremental cost of AVUV is worth it for the stronger value tilt and better performance” [1].

Conclusion: A Call for Precision in Portfolio Construction

VIOV’s underperformance is not a failure of the small-cap value strategy itself but a reflection of its construction flaws. Passive strategies like VIOV offer liquidity and low costs but lack the factor purity and dynamic stock selection of active alternatives like AVUV and DFAT. For investors seeking to capture the Size and Value premiums effectively, the data suggests that prioritizing factor loading and portfolio efficiency may outweigh the allure of minimal fees.

Source:
[1] VIOV vs VBR, AVUV, IJS, SLYV, DFAT, & ISCV [https://www.optimizedportfolio.com/small-value-showdown/]
[2] Best Small Cap Value ETF? (AVUV, DFAT, RZV, VBR) [https://www.bogleheads.org/forum/viewtopic.php?t=431041]