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Shining The Transparency Light On ETFs

Mike Venuto

Taking advantage of one of the greatest benefits of ETFs—transparency—can lead to some surprising discoveries. Case in point: the world of small-cap ETFs.

We’ve discovered that while a number of ETFs call themselves “small-caps,” they really don't have that much small-cap exposure. And that matters, because a fund that isn’t exactly small-cap is going to deliver different risks and different returns than a pure small-cap strategy.

Clarifying Terms

To be clear, at Toroso, we define small-caps as those having less than $2 billion in market capitalization, which appears to be the most common independent definition. It's not that anyone else is wrong about what constitutes a small-cap stock or a small-cap ETF, it’s just that others may be defining it differently.

With that in mind, let’s take advantage of the transparency of ETFs, dig a little bit deeper and look into the entire Vanguard lineup to see what we can learn.

Back in 2013, when we first examined the characteristics of small-cap ETFs, we pointed out that the Vanguard Small-Cap ETF (VB), which is based on the CRSP US Small Cap Index, had only about 35% small-caps.

Today VB has even less than that—21.8% small-caps. Compare that to the 64% small-caps in the iShares Core S&P Small Cap ETF (IJR), which uses the S&P SmallCap 600 Index, and it’s clear that this can really matter.

In the world of active management, this differentiation is often called “mission drift,” and can be the source of significant dispersion. A byproduct of ETF asset growth appears to be a passive form of mission drift, which is easy to monitor when you embrace the transparency of ETFs.

Looking Under The Vanguard Hood         

So let’s look at Vanguard’s lineup, with a view of taking measure of the overlaps between different size categories—both in terms of percentages and actual positions. I want to achieve a few things here:

  • We're going to hone in on a few of those overlapping positions and see how it affects the fundamentals of those specific securities or positions.
  • We also discovered a “value factor” bias that resides in some of these ETFs that I want to discuss.
  • We're further going to compare the value and growth approaches of the CRSP indices Vanguard uses with those of S&P indices, which underlie widely held ETFs from both iShares and State Street Global Advisors
  • Finally, I want to discuss whether these things can all be combined, and how those combinations affect overall asset allocation approaches.

So let's dive right into it. The chart below shows a slew of ETFs from Vanguard: a mega-cap fund as well as the value and growth versions of mega caps; the Vanguard large-cap fund as well as the value and growth versions; the midcap ETF and value and growth versions of midcaps; and the small-cap ETF VB and the value and growth versions of VB. 

% Overlap by Position Weights 

Source: ETFresearchcenter.com, as of April 30, 2017


Considerable Overlaps

The first thing that really stands out is that there are securities or percentage overlaps that are pretty high.

For example, the Vanguard Large-Cap ETF (VV) has an 84% overlap with the Vanguard Mega-Cap ETF (MGC). But that mega-cap fund has overlaps with the midcap ETFs, and a tiny overlap with the small-caps. (We’ll get into how that overlap with the small-cap ETF happens later. But as you can see, there are a lot of overlaps among these indexes, no matter their stated approach.)

Let’s look more closely at VV, the large-cap ETF. Again, it has overlap with the mid-, small- and large-caps. In fact, the large-cap ETF owns basically everything that’s in the midcap ETF, as well 20 securities that are part of the small-cap. This analysis of percentages gives us an idea of how these things can be put together in a portfolio context.

Drilling Deeper

So, let’s look at actual position overlaps. This is really where things start to get illuminating. The first position overlap that really stands out is that there’s one security in the small-cap ETF that's also in the mega-cap ETF. Also, there are 12 securities in the Vanguard Midcap ETF (VO) that are also in the mega-cap ETF. 

% Overlap by Number of Positions

Source: ETFresearchcenter.com, as of April 30, 2017


The mega-cap and small-cap overlap at first sounds like a great story, but it’s not that exciting, because that one security that’s in both the mega- and small-cap fund—a company called Computer Sciences—is a spin-off. The discrepancy likely will be addressed during the next rebalance.

Too Much ETF Ownership?

That said, 22 securities in the large-cap index are also in the small-cap index. We honed in on the top positions to get a better feel for what these overlaps might mean, and the one position that really stood out was Targa Resources. Targa was by far the position I saw most often across large-, mid- and small-cap strategies.

TRGP is only in 53 ETFs, yet almost 14% of the company’s market cap is owned by those ETFs. Also, its forward price-to-earnings multiple (P/E) is 82 times earnings. Targa is a master limited partnership (MLP), so I compared its P/E to that of the Alerian MLP Index, which is at 21 times. 


% of TRGP Market Cap Owned by US ETFs

Source: Toroso Ownership Influence Tool ,as of April 30, 2017


TRGP’s elevated P/E is one clear sign of how index overlap across the capitalization spectrum may contribute to demand for an individual security and potentially cause its price to be overvalued.

Examining A Value Bias

As I briefly mentioned above, we found that this index-overlap phenomenon also has a value factor tie-in. So let's take a look at this unexpected value bias. 

% Overlap by Position Weights Between Vanguard Core/Value/Growth Lineup 

Source: ETFresearchcenter.com, as of April 30, 2017


While looking at all the overlaps, I noticed that Vanguard core products that are focused on mega-caps, large-caps, midcaps and small-caps all have more overlap with their value strategies than with their growth strategies. In other words, the Vanguard approach, at this time, has an inherent value bias.

This analysis illustrates how valuable ETF transparency can be. You can discover what you actually own. The question is: Do you own core strategies, or is it that Vanguard’s approach has a value bias? The answer is important to correctly align the risks you’re taking with the risks you want to take.


Assembling The Pieces

Given this value bias we uncovered, we examined how these different funds look when you put them together. We took a look at iShares ETFs that use S&P indices and compared them to similar Vanguard ETFs that use indices from CRSP. 

% Overlap by Position Weights Between Vanguard & iShares Value/Growth Lineup 

Source: ETFresearchcenter.com, as of April 30, 2017


The first thing that stood out to me is that, in this case, combining the Vanguard versions makes a lot more sense. The Vanguard Value ETF (VTV) and the Vanguard Growth ETF (VUG) only have 5% overlap with each other. Making the same comparison with the S&P value and growth indices that iShares uses in value and growth strategies, you find those strategies have an overlap of 29% with each other. So it does seem that Vanguard has purer versions of getting exposure to value versus growth.

The other thing that's very interesting is that even though each pair of funds is quite different in terms of value and growth overlaps, the iShares S&P 500 Value ETF (IVE) has a 69% overlap with VTV, the Vanguard value strategy. In other words, they're very similar, as are the Vanguard growth ETF, VUG, and the iShares S&P 500 Growth ETF (IVW), which also had a 69% overlap.

Problems At The Portfolio Level

Now, let's take a look at how these things would work in a portfolio together.

% Overlap by Position Weights Between Vanguard/CRSP and S&P Approach 

Source: ETFresearchcenter.com, as of April 30, 2017


In the chart above, we took S&P-indexed versions of large-, mid- and small-cap funds from SSgA and iShares, and compared them with competing large-, mid- and small-cap versions of these strategies from Vanguard.

Assuming that you're building a portfolio where you're combining Vanguard’s small-cap ETF VB with the SPDR MidCap 400 ETF (MDY), you’d have a 43% overlap. In other words, you wouldn't really end up with much in the way of small-cap exposure.

Even more concerning is if you compare SSgA’s MDY with the Vanguard Mid-Cap ETF (VO), you’d only find an overlap of 7%. How is that possible?

Worse yet, comparing the Vanguard’s small-cap ETF, VB, with the iShares Core Small Cap ETF (IJR), you find just 17% overlap.


I bring all this up not because there's something wrong with the Vanguard approach or right with the iShares or SPDR approach, or vice versa. It's simply that knowing these details is very important for how you combine funds to come up with a coherent portfolio that has thoughtful asset allocation that tilts accurately to the factors you want to be exposed to—whether that’s small-caps and midcaps, or growth and value.

Not too long ago, I saw many advisors gravitate toward VB, the Vanguard small-cap ETF, because it outperformed the other small-cap ETFs. The problem is that it didn’t exactly “outperform” other small-cap funds. What happened is that because of its composition, it performed like a midcap ETF, and midcaps happened to be outperforming small-caps at that time.

Investors need to embrace the transparency of ETFs and look beyond just the name, expense ratio and past performance. Understanding the index construction and fundamentals behind an ETF can help you make good investment decisions with how to develop an intelligent ETF portfolio.

So, what’s the moral of the story? ETFs are amazingly transparent, but unless you actually look under the hood, you may not truly know what you own. And mission drift can have big consequences.

Toroso does not hold positions in any of the ETFs referenced in our core portfolios. Some ETFs referenced maybe available as allocations in 401(k) plans we oversee. Toroso is affiliated with Global X Management Company. Toroso is a New York-based investment advisor focused on researching ETFs and other exchange-traded products, and designing asset allocation strategies, using ETFs that seek to perform well in various economic climates while emphasizing future objectives over past correlations. For more information about Toroso, call 646-465-5930, visit www.torosoinv.com or email info@torosoinv.com. For a list of relevant disclosures, please click here.


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