Best & Worst ETFs and 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 24 ETFs and 629 mutual funds in the Small Cap Blend style as of October 24, 2013. Prior reports on the best & worst ETFs and mutual funds in every sector and style are here.

Figure 1 shows the five best and worst-rated small-cap blend ETFs and Figure 2 ranks from best to worst the ten small-cap blend mutual funds that meet our liquidity standards. Not all Small Cap Blend style ETFs and mutual funds are created the same. The number of holdings varies widely (from 22 to 2249). This variation creates drastically different investment implications and, therefore, 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.Here’s the list of our top-rated stocks.

Get my ratings on all ETFs and mutual funds in this style by searching for Small Cap Blend on my freemutual fund and ETF screener.

WisdomTree U.S. Small Cap Dividend Growth Fund (DGRS), Vanguard S&P Small Cap 600 ETF (VIOO) and PowerShares RAFI Fundamental Pure Small Core Portfolio (PXSC) are excluded from Figure 1 because each of their total net assets (TNA) are below $100 million and do not meet our liquidity minimums.

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

Boston Trust Walden Mid Cap Fund (WAMFX) is excluded from Figure 2 because its total net assets (TNA) are below $100 million and do not meet our liquidity minimums.

First Trust DJ Select Micro Cap Index Fund (FDM) is my top-rated Small Cap Blend ETF and Royce Special Equity fund (RSEIX) is my top-rated Small Cap Blend mutual fund. FDM gets my Dangerous rating, while RSEIX earns my Neutral rating.

iShares Micro Cap ETF (IWC) is my worst-rated Small Cap Blend ETF and ProFunds Small Cap ProFund (SLPSX) is my worst-rated Small Cap Blend mutual fund. IWC gets my Dangerous rating, while SLPSX gets my Very Dangerous rating.

Figure 3 shows that 273 out of the 2528 stocks (over 13% of the market value) in Small Cap Blend ETFs and mutual funds get an Attractive-or-better rating. However, only zero out of 24 Small Cap Blend ETFs and zero out of 629 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 few earn above a Dangerous rating. However, zero ETFs and zero mutual funds in the Small Cap Blend style allocate enough value to Attractive-or-better-rated stocks to earn an Attractive rating. Investors would be better off focusing on individual small cap stocks instead.

GameStop Corp. (GME) is one of my favorite stocks held by Small Cap Blend ETFs and mutual funds and earns my Attractive rating. GME has grown profits (NOPAT) by 24% compounded annually since 2003 and has a return on invested capital (ROIC) of 11%. GME has also earned positive and growingeconomic earnings since 2004. Despite this strong profit growth track record, the stock is inexpensive. To justify the current price (~$54/share), GME must grow profits by only 5% compounded annually for just 6 years. With the release of several next-generation gaming consoles right around the corner and GME’s excellent track record of profit growth, these expectations for the near future seem low. There is still value left in this stock and investors should take advantage.

Hornbeck Offshore Services (HOS) is one of my least favorite stocks held by Small Cap Blend ETFs and mutual funds and earns my Dangerous rating. HOS has a return on invested capital (ROIC) of just 4%, which puts it in the bottom quintile of all companies I cover. HOS has also seen its profits (NOPAT) decline from $115 million in 2008 to under $82 million in 2012. Moreover, HOS has earned negativeeconomic earnings for each of the past four years. With such a recent decline in profitability, it is surprising that HOS is trading at ~$58/share. To justify this stock price, HOS would need to grow profits by 28% compounded annually for the next 9 years. Remember, these expectations are for a company that has seen its profits decline by 29% over the past 4 years. HOS is priced to achieve unrealistic cash flow growth. Investors should avoid this stock as long as it is this expensive.

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 24 ETFs and 629 mutual funds in the Small Cap Blend style.

André Rouillard and Jared Melnyk contributed to this report.

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