Best & Worst ETFs & Mutual Funds: 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 23 ETFs and 639 mutual funds in the Small Cap Blend style as of July 18, 2013. 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 12 to 2288), 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 expensesof 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 on my free mutual fund and ETF screener.

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

PowerShares RAFI Fundamental Pure Small Core Portfolio (PXSC), PowerShares S&P Small Cap Low Volatility Portfolio (XSLV) and Vanguard S&P Small Cap 600 ETF (VIOO) are excluded from Figure 1 because each of 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.

Quaker Small Cap Value Fund (QSVIX) is excluded from Figure 2 because its total net assets (TNA) are below $100 million and do not meet our liquidity standards.

First Trust Small Cap Core AlphaDEX Fund (FYX) is my top-rated Small Cap Blend ETF and Royce Special Equity Fund (RSEIX) is my top-rated Small Cap Blend mutual fund. FYX gets my Dangerous rating, while RSEIX gets my Neutral rating.

iShares Micro Cap ETF (IWC) is my worst-rated Small Cap Blend ETF and TFS Small Cap Fund (TFSSX) is my worst-rated Small Cap Blend mutual fund. IWX gets my Dangerous rating, while RSEIX receives my Very Dangerous rating.

Figure 3 shows that 320 out of the 2536 stocks (over 14% of the market value) in Small Cap Blend ETFs and mutual funds get an Attractive-or-better rating. However, zero out of 23 Small Cap Blend ETFs and zero out of 639 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.

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 just a handful receive above a Dangerous rating. 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 should focus on individual Small Cap stocks instead.

American Eagle Outfitters (AEO) is one of my favorite stocks held by Small Cap Blend ETFs and mutual funds and earns my Very Attractive rating. AEO has grown profits (NOPAT) by 18% compounded annually since 1998. This consistent profit growth helps AEO achieve a return on invested capital (ROIC) of 15%, which ranks in the top quintile of all companies I cover. AEO has also earned positive economic earningsevery year since the beginning of my model. Despite AEO’s excellent profit track record, it is still trading at ~$19/share, which gives it a price to economic book value ratio of 0.9. This ratio means that the market expects AEO’s profits to permanently decline by 10%. The upcoming back to school season and AEO’s history of consistent growth, however, give investors reason to be bullish about the company’s future in the short and long term. Investors should consider this stock at its current price while there is still value to be had.

FelCor Lodging Trust (FCH) is one of my least favorite stocks held by Small Cap Blend ETFs and mutual funds and earns my Dangerous rating. FCH’s profits (NOPAT) have fallen by 7% compounded annually since 1999, and the company has earned negative economic earnings every year during that period as well. While FCH’s profit track record is not reassuring, neither is its future. As per my Danger Zone article, stock prices of REITs have been unsupported by their fundamentals. Rising interest rates will cause investors to put their money in more traditional yield investments, as people shy away from REITs and their dividends that have been popular during the past few years of very low interest rates. Rising interest rates will also slow lending that spurs new construction projects. REITs like FCH will become less attractive places to make money, and the stock prices will fall as investors leave for better opportunities.

At its current price of ~$6/share, FCH would need to grow NOPAT by 12% compounded annually for the next 11 years. FCH’s shrinking profits and my outlook for REITs indicate that this stock is too expensive. Investors should avoid overvalued REITs like FCH.

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 23 ETFs and 639 mutual funds in the Small Cap Blend style.

André Rouillard contributed to this report.

Disclosure: David Trainer and André Rouillard receive no compensation to write about any specific stock, sector, style or theme.