Vanguard VO + VB Vs. VXF: Picking The Better ETF Strategy (NYSEARCA:VB)

(This article was co-produced with Hoya Capital Real Estate)

Introduction

One advantage of having thousands of ETFs to purchase is that it gives investors the ability to divide the US equity market into sub-components and decide their own allocation instead of relying on a broad-base ETF that covers the whole range of the market-cap stocks available. For investors who uses momentum models, they might be able to add Alpha to their portfolio by switching between funds. In two articles, Using A Large-Cap/Small-Cap Model To Beat The Market and Skip Vanguard’s VV ETF And Build Your Own Growth And Value Allocation Using The VUG And VTV ETFs, I covered how some Alpha was possible by moving between ETFs with different strategies.

This article looks at two strategies using the Vanguard Mid Cap ETF (VO) and the Vanguard Small Cap ETF (VB) combined versus just investing in the Vanguard Extended Market Index ETF (VXF). The strategies reviewed are:

• Owning the VO ETF and VB ETF in weights that best suits the investor and comparing those results against owning the VXF ETF, where the investor doesn’t control the allocation between Mid-Cap and Small-Cap stocks.
• Using a momentum model to pick which ETF, VO or VB, at a 100% allocation until the model says switch, and comparing that results against just doing a buy/hold with VXF.

After running several tests, the results do not seem to favor either combined strategy, with the actual best strategy appearing from the data generated by one of those iffy ideas.

Understanding the Vanguard Mid Cap ETF

Seeking Alpha describes this ETF as:

Vanguard Mid-Cap ETF is an exchange traded fund launched and managed by The Vanguard Group, Inc. It invests in public equity markets of the United States. It invests in stocks of companies operating across diversified sectors. The fund invests in growth and value stocks of mid-cap companies. The fund seeks to track the performance of the CRSP US Mid Cap Index. VB ETF started in 2004.

VO has $48b in AUM and currently yields 1.25%. Vanguard charges 4bps in fees.

The sector allocation is slightly less tech-weighted than a S&P 500 ETF. Compared to the Vanguard S&P 500 ETF (VOO), Industrials moved from the sixth place to second here. Real Estate’s allocation is triple what VOO holds.

At 377 assets and the Top 10 under 7%, the ETF is well diversified and not dependent on a small set of stocks to drive results.

Dividend growth the past 5 years has been 8.46%, though the 3-year rate is half that. Seeking Alpha grades their dividend performance a “B”.

Understanding the Vanguard Small Cap ETF

Seeking Alpha describes this ETF as:

Vanguard Small-Cap ETF is an exchange traded fund launched and managed by The Vanguard Group, Inc. The fund invests in public equity markets of the United States. The fund invests in stocks of companies operating across diversified sectors. The fund invests in growth and value stocks of small-cap companies. The fund seeks to track the performance of the CRSP US Small Cap Index. VO ETF started in 2004.

VB is almost as large as the VO ETF at $42.4b in AUM. VB has a slightly higher yield of 1.38%. Vanguard charges 5bps in fees.

Here we see Industrials taking over as the largest allocation, bumping Technology down to #2. The Top 6 sectors match those in VO, but in a different order.

VB hold almost 5X the number of stocks that VO holds and this is reflected in the 3.23% the Top 10 represents; much smaller than VO’s Top 10 stocks.

From the bump in the most December dividend payouts, it appears Small-Cap stocks like paying enhanced year-end dividends. With a higher 3-yr and 5-yr dividend growth rates, VB earned a “B+” from Seeking Alpha on this measure.

Understanding the Vanguard Extended Market Index ETF

Seeking Alpha describes this ETF as:

Vanguard Extended Market ETF is an exchange traded fund launched and managed by The Vanguard Group, Inc. It invests in public equity markets of the United States. It invests in stocks of companies operating across diversified sectors. It invests in growth and value stocks of companies across diversified market capitalization. The fund seeks to track the performance of the Standard & Poor’s Completion Index. VXF started in 2001.

VXF is the smallest of the three ETFs at only $14.7b in AUM. Vanguard charges more in fees too: 6bps. The current yield is 1.3%.

You can see how changing indices affects the allocation as Technology is back on top but with a percent greater than either of the other two ETFs. Like VO and VB, Financials and Health Care are near the top, with Energy and Utilities pulling up the rear.

A big surprise is there is no overlap in the Top 10 here, nor with the VO ETF that holds the larger market-cap stocks. VXF hold far more stocks than either of the other ETFs, even so, the Top 10 are over 7% of the assets, more than VO’s, with 10X the number of stocks. That equates to VXF holding numerous stocks whose weight is so small they matter little to the ETFs performance.

Again, we can see the year-end payout is the highest for the year in each of the last five years. Seeking Alpha give VXF an “A” rating for dividends.

Two possible strategic paths outlined

While the combination of ETFs would duplicate VXF’s Mid-Cap/Small-Cap strategy, with VXF using the S&P Completion Index, the universe varies greatly from the CRSP Indices used by the other two ETFS, especially in the number of stocks included (3729 vs 1943). VXF and VO have 98 stocks in common, with 16% overlap in market value. With VB, VXF has 1330 common stocks and 41% market value overlap. This difference possibly will effect both strategy results.

Variables/Data that needs to be considered

There are certain data series I consider important to review as I believe they will help determine if there is any purpose to try either strategy to be discussed next.

Class performance

Obviously, if Mid-Cap and Small-Cap stocks have generated returns that closely match over various periods, then how an investor allocates between them should not produce much, if any, Alpha.

Since 1972, Mid-Cap and Small-Cap stocks have performed about the same, with Mid-Cap 35bps to the good. This doesn’t seem to support gaining Alpha via either suggested strategy.

Class correlation

This data series is more criterial to the momentum strategy. Even if long-term results are close, short-term movements could produce Alpha if patterns can be exploited.

Correlation data also does not support much hope that any momentum model would add Alpha with all the values being at and over 97%.

ETF purity

Since different indices classify stocks differently, in this case, by market-cap, both strategies depend on each ETF holding only, or almost only, stocks in the market-cap reflected by the name of the ETF. Here is a recent allocation between the asset sizes as defined by Fidelity.

While VO has a decent ‘purity #’ at 82%, its Large-Cap number exceeds that of VXF. VB seems unable to make-up its mind if it’s a Mid- or Small-Cap ETF. As a backup, I checked the allocations on ETFDB.com (Vanguard did not show this data), and that data skewed both VO and VB even more into stocks above their target group. My conclusion is while the VO ETF is usable for either strategy, a different Small-Cap ETF would be needed to be found.

Flexible allocation strategy

In its basic form, the investor picks the weight to hold between each ETF. While here I am only considering Mid-Cap and Small-Cap stocks, there are Large-Cap ETFs like the Vanguard S&P 500 Trust ETF (NYSEARCA:SPY), and Micro-Cap ETFs like the iShares Micro-Cap ETF (NYSEARCA:IWC). Here, using VO and VB, one can run various combinations to see if any provided better results than keeping it simple by owning just VXF.

As one might have expected after the previous chart, overweighting Mid-Cap stocks via the VB ETF, does provide 21bps in Alpha, though it requires annual rebalancing. Changing the rebalancing to more frequency did not materially change the results. If done in a taxable account, taxes owed might eat up most, if not, all the extra basis-points earned.

Momentum strategy

After looking at the data, my preferred 3-month momentum model did not appear to generate much switching, so I ran the analysis using a 2-month model. By that, I owned the ETF that had the best performance two months in a row; otherwise, I continued to own the last one with that tract. Using data back to early 2004, this resulted in owning VO or VB about 50% of the time that ETF had the best performance. In other words, an investor could have invested by flipping a coin and would have been as accurate. As of the end of January, the ending value of each holding, VXF, VO, VB, and the 2-month strategy were:

Even more than expected due to closeness of both long-term CAGR and tight correlations, the 2-month momentum strategy generated the worst outcome. With the investor only in the better performing ETF 50% of the time, the final value reflects that. The real result is, especially for investors light on Mid-Cap stocks, owning VB or other Mid-Cap focused ETF is worth some research.

Portfolio strategy

While this article discussed allocating between US stocks based on asset-size (Micro-cap is a 4th set), another strategy to research is Growth vs. Value stocks, which seems to have better ability to generate Alpha if a decent momentum model can be developed. While International-Developed stocks have trailed US stocks for over a decade, Emerging Markets stocks are ahead over both the last 10 and 15 year periods. One benefit of all these different strategies is they are not 100% correlated; unfortunately all markets are more correlated than they were 20-40 years ago.

Tested Strategies Conclusion

Sometimes the most important thing you get from testing investment ideas is you find that they add complexity, possible trading taxes, and little in enhanced CAGR. That is what I glean from the Flexible Allocation strategy. The 2-month momentum strategy was a complete dud here, unlike when I did the same using a 3-month model on other pairs of ETFs.

The best results since 2004 would have been owning the VO ETF, both in terms of CAGR and superior StdDev. Of course, then you can decide on mixed, growth, or value. Vanguard offers both: Vanguard Mid-Cap Growth ETF (VOT) and Vanguard Mid-Cap Value ETF (VOE). Here we find VOT achieving the highest CAGR since 2006, when it started in September.

Recent review of each ETF on Seeking Alpha

VO: A Short-Term Trade And A Long-Term Investment

VB: Valuation Risks, Volatility Risks And Hedging

Thanks To Put Writing, I Own VXF; So A New Review Was In Order

Any due diligence should include reading what other people think about any investment they are considering. Seeking Alpha also contains data about each ETF, covering any facet of those funds that I can think investors would need to evaluate that possible investment.