I have been investing for about 15 years. During this time, the vast majority of my investments have been in individual stocks. But I recently invested a significant portion of my wealth, about 12%, in an exchange-traded fund, or ETFs.
The ETF provides exposure to a segment of the market where I previously didn’t have any. This was a big hole in my portfolio, but represents a great opportunity for long-term investors. And this opportunity looks increasingly attractive in today’s market.
While I could have done some research to learn more about specific stocks in this segment, there were several reasons why I thought an ETF would work better than relying on individual names. So during the recent market sell-off, I purchased shares of the Avantis US Small Cap Value ETF (NYSEMKT:AVUV).
Why I finally pulled the trigger
Small-cap stocks have recently fallen out of favor. And by “recently,” I mean the last decade. Small-cap value stocks fared even worse.
This is how the return of Russell 2000 Value Index compares to S&P500 over the last 10 years.
Small-cap value stocks have underperformed large-cap stocks in seven of the last ten calendar years.
This led to a significant valuation gap. Small-cap stocks were trading 17% below their historical average forward price-to-earnings (P/E) ratio at the end of 2023. Meanwhile, large-cap stocks were trading 15% below – above their historical average, according to data compiled by American Century. This is reflected in the Avantis US Small Cap ETF’s current P/E ratio of 7.8, compared to the S&P 500, which has a current P/E ratio of 26.2.
The valuation gap between small- and large-cap stocks hasn’t been this wide in decades. This suggests that the upside potential of small caps is much greater than the downside risk. This is especially true given very long-term historical trends.
Over the very long term, small-cap value stocks are the best-performing group of stocks in the investment market. And while it hasn’t worked lately, there are fundamental reasons why it should remain true in the future. Specifically, small businesses should benefit from a higher risk premium. That is, because smaller companies are generally riskier investments than larger, more established companies, investors demand a higher expected return.
This risk premium has only recently increased due to the Federal Reserve’s interest rate policies intended to combat inflation. As interest rates rise, the risk-free rate rises, and thus the risk premium. So when investors demand higher returns for their small-cap stocks over the long term, it means the stock price must fall today in order to be able to produce higher returns in the future. But for long-term investors, this represents a buying opportunity.
Why I opted for an ETF
Researching large-cap stocks is easy. In addition to the quarterly financial reports that every publicly traded company is required to provide, there is plenty of media coverage and Wall Street analyst notes to read. These stocks are very liquid with…
