EC The Problem With Small-Cap Value Indexes

Part I: Indexing Idiocy

MSCI’s value index (MGV, VTV) is seriously lagging behind the USA index (EUSA, PBUS). Its ten-year, five-year, three-year, and one-year CAGRs are all lower. The small-cap index (PBSM) is still ahead if you look at its ten-year CAGR, but way behind on its five-year, three-year, and one-year numbers. And MSCI’s small-cap value index (VBR) has been utterly pitiful: its one-year return as of the end of January was 8.94%, compared to 25.54% for the USA index; its ten-year, five-year, and three-year numbers are also really low. All this has prompted remarks among some investors that the advantages of value and small-caps seem to be vanishing.

This all seems like nonsense to me. Value disappearing? Small caps not doing well? I invest only in low-priced small caps and microcaps, and I made 45% in 2016 and 58% in 2017.

Here’s what’s actually going on: not much has really changed.

If you define “value,” as MSCI does, as a combination of low price-to-book, low P/E, and high dividend yield, you’re defining value all wrong. The price-to-book ratio is one of the worst value ratios you can come up with, since it rewards companies with little to no leverage rather than companies that are using their leverage wisely (I’ve written at length about this here). High dividend yield is only a good thing if the company isn’t paying out more than it takes in (I’ve written at length about this here).

And MSCI isn’t the worst offender at all.

Read the fine print as to how Russell defines its value indexes (IUSV, IWD, IWN, IWS, IWX, OVLU, PXLV, PXMV, PXSV, VONV, VTWV). It creates a three-pronged ranking system. Fifty percent is based on the terrible price-to-book ratio. The other fifty percent is made up of a medium-term growth forecast and the company’s five-year-historical sales growth per share, but ranked negatively, so that the companies with least growth potential get ranked the highest. It’s almost as if they’ve designed the index to fail. And, sure enough, it has. Total returns of the Russell 2000 Value index, as of the end of January, are seriously lagging the Russell 3000 by every single measure from one month to ten years.

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