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Small-cap value stocks outperform in the long run. They are riskier, turning off some investors. They are too small for many large institutional investors. The entire U.S. stock market is valued at around $44 trillion, and the value of all the companies in DFSV’s portfolio come to less than $4 trillion. Not only is it hard to invest but it is even harder to get out. Therefore, this space is avoided by most institutions and large investors or only gets a proportionate value of their assets, less than 10 percent of an equity allocation.

In addition to being passed over by large investors, small-cap value stocks are also avoided by financial analysts since there isn’t a great deal of interest. This means investors have to do their own research, which the vast majority do not. These stocks are also more volatile, which turns off conservative investors. Paradoxically, all these negatives probably explain small-cap value’s outperformance. Most of the time, this asset class is trading at a discount.

Dimensional Fund Advisors is a fund provider based on the academic research of Eugene Fama and Kenneth French. Many of the funds using factor-based methods base their models directly on the work of Fama and French or derived models that use their research as a starting point. Dimensional goes straight to the source — Fama sits on Dimensional’s board of directors.

In a nutshell, they created a new asset pricing model after finding that small-cap stocks with low price-to-book ratios outperformed the market. This shouldn’t be the case if variations in stock returns were mostly random, something that earlier academic research showed. This was sometimes described as the “random walk” theory. Investors who believe in this theory would do best buying a passive fund covering the entire market, such as the S&P 500 Index. In contrast, Fama and French’s work suggested asset allocation among market segments, such as market capitalization and traditional growth and value, or international and so on, had an impact on returns. Later, they discovered that other factors such as momentum could explain returns and thus be used as the basis for investment selection.

The market segment that showed the best performance was small-cap value, as shown in the earlier work of Fama and French. In 2022, Dimensional Advisors launched an ETF based on their work: Dimensional U.S. Small Cap Value (DFSV). Since the launch of DFSV in February, it has consistently outperformed iShares Russell 2000 (IWM) as well as small-cap value competitors such as Vanguard Small-Cap Value (VBR) and SPDR S&P Small-Cap Value (SLYV).

Investment Strategy

DFSV starts its universe with the cheapest 10 percent of the U.S. stock market as measured by market capitalization. It then narrows this universe by hunting for stocks with lower price-to-book ratios, cutting off at the bottom third. It looks for companies with higher profitability that haven’t been aggressively expanding. Short-term signals such as price momentum can also be a criterion for investment. Liquidity screens and the need to keep turnover low also impact which stocks make it into the portfolio. Holdings are weighted by market capitalization as a way of keeping turnover down.

Costs are kept low, but at 0.31 percent, it’s relatively pricey compared with passive alternatives such as VBR and its 0.07 percent cost.

DFSV has already earned a Morningstar Silver rating.

Portfolio

DFSV currently holds 957 stocks. The weighted average market capitalization is $3.4 billion. The portfolio of stocks has an aggregate price-to-book ratio of 1.27, which compares with 1.99 for the Russell 2000 Index and 1.33 for the Russell 2000 Value Index.

Financials dominate the portfolio with a 27 percent allocation, but this isn’t far above the benchmark’s 24 percent. Industrials are also slightly overweight at 20 percent of assets. Consumer cyclicals are in line with the benchmark at 14 percent of assets. Energy at 9 percent is overweight by three percentage points. Technology rounds out the top five at 8 percent of assets, underweight by 1 percent. Utilities, healthcare and real estate are the sectors with the largest underweighting.

The top 10 holdings have a small percentage of assets, as expected in a diversified fund with nearly 1,000 holdings. Allocations in the top holdings range from 0.76 percent of assets down to 0.54 percent. At the top is Transocean (RIG), followed by Commercial Metals (CMC), TechnipFMC (FTI), IPG Photonics (IPGP), Bank OZL (OZK), Foot Locker (FL), New York Community Bank (NYCB), FNB Corp. (FNB), Jackson Financial (JXN) and Genworth Financial (GNW).

DFSV doesn’t have enough history for beta and standard deviation, but a sister mutual fund trades under the symbol DSFVX. It has a beta of 1.18 and a standard deviation of 29.26, making it more volatile than the Small-Cap Value category on both scores, albeit only slightly.

Performance

DFSV has gained 12.80 percent in 2023, beating both the category and the benchmark index. It has similarly beaten both since its inception a little less than one year ago.

Its sister fund DFSVX has a long history of performance. Over the past 20 years, it has gained 800 percent, well ahead of iShares Russell 2000 Value’s (IWN) 547 percent. Over the past 15 years, it gained 278 percent to IWN’s 209 percent. DFSVX ranks in at least the top 27 percent of small-cap value funds over the past 5-, 10- and 15-year periods.

Notably, DFSVX performed much better in the past year. It gained 6.50 percent, while the category and index rose less than 2 percent. This landed it in the top 13 percent of funds. Both DFSVX and DFSV made new all-time highs in February of this year. This shows the fund can also outperform in down markets.

Caution is warranted though. In 2008, DFSVX lost 67 percent from high to low. While there are some signs the current market resembles the early 2000s (DFSV’s performance this past year reinforces this comparison) and DFSVX did end up gaining over the entirety of that bear market, it would be unwise for investors to assume a repeat should markets turn lower.

Outlook

DFSV is one of the top options for investors seeking small-cap value exposure. Although DFSV is a little more expensive than the competition, if it can do as well as its mutual fund counterpart DFSVX, it can more than make up for the higher expense ratio. For example, DFSV is outperforming VBR by several percentage points in 2023, with about six weeks of trading done. That dwarfs the difference in their expense ratios.

DFSV can serve as a core holding for younger and more aggressive investors with longer time horizons. More conservative investors should stick to smaller satellite positions, although investors can be more aggressive in bear markets and major corrections when adding the fund offers a much stronger risk/reward proposition.

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Healthcare was one of the few bright spots in an otherwise down year for the stock market. Although the sector lost ground, strength in pharmaceutical stocks kept losses in the low single digits for most diversified sector funds. The actively managed Vanguard Health Care (VGHCX) came out ahead of the pack with a decline of 1.05 percent, about 1 percentage point ahead of the overall sector. By comparison, the S&P 500 Index was weighed down by its hefty technology exposure. Vanguard 500 (VOO) slid 18.17 percent on the year.

The stable results by healthcare stocks in 2022 were consistent with their performance history. Major healthcare companies are typically large firms with diversified or stable income streams. Johnson & Johnson (JNJ) best exemplifies the diversified company. It sells all manner of goods ranging from medicine to household products. Shares gained nearly 6 percent in 2022. UnitedHealth Group (UNH) represents the other side of stable. It has a narrower business model, but consumers need healthcare year in and year out whether there is a recession or not.

Medical devices, pharmaceuticals and biotechnology make up the bulk of the remaining firms. These companies are often highly volatile in their early life because they have no income and trade entirely on the hope of hitting a discovery. If they make one, they graduate into being more stable earners.

Pharmaceuticals giants were the driving force behind healthcare gains last year with several enjoying double-digit gains such as Merck (MRK), Bristol-Myers (BMY) and Novo Nordisk (NVO). Pharma strength has waned early in 2023, although mid- and small-cap pharma companies are among the best-performing healthcare stocks this year. Medical devices and biotechnology, the two weakest subsectors in 2022, have led this year thanks to the bounce in technology and growth stocks.

The mix of growth and defensive subsectors makes healthcare a desirable sector for many investors. Other sectors experience boom-bust cycles where they lead for long periods and then underperform. Healthcare is a steadier performer often found in the middle of the pack because it has a healthy mix of growth and value exposure.

Vanguard has two main options for accessing this sector. Vanguard Health Care (VHT) is the passive ETF with an expense ratio of 0.10 percent and a yield of 1.31 percent. The other was the better performer in 2022: Vanguard Health Care (VGHCX). It has an expense ratio of 0.30 percent and 30-day SEC yield of 0.75 percent.

Management

Jean Hynes was named a co-manager of VGHCX in 2008 and took over as lead manager in 2013. She has been an analyst at Wellington Management Company since 1991, covering the healthcare sector. Two years ago, she was named CEO of Wellington. Despite the increased workload, she has stayed on as manager thanks in part to her large and capable team of analysts. She also stepped down from managing a separate healthcare fund, Hartford Healthcare (HGHAX).

VGHCX’s mandate calls for long-term capital appreciation. Management is tasked with investing in health services, medical products, specialty pharmaceuticals, major pharmaceuticals and international markets. The fund hunts for strong companies selling at a discount and will take contrarian positions in companies hit with negative events. The fund overweights the top holdings to the tune of about 30 percent of assets. Turnover is low at 15 percent, which translates to a nearly 7-year average holding period.

VGHCX has a 4-star and Silver rating from Morningstar.

Portfolio

VGHCX has an average market capitalization of $68 billion, more than the healthcare category average of $52 billion but below the index average of $102 billion. VGHCX is very similar to the index in that giant- and large-cap stocks make up 78 percent of assets versus 80 percent for the index. It differs from the category because it has less mid- and small-cap exposure.

VGHCX also differentiates itself geographically. It has nearly 9 percent of assets in Japan, 7 percent in the United Kingdom and 5 percent in Switzerland. The category has more than 90 percent invested in the U.S., and the index has nearly 100 percent.

Subsector exposure is led by 38 percent in pharmaceuticals, 22 percent in biotechnology, 14 percent in managed healthcare, 12 percent in healthcare equipment and 9 percent in life sciences tools and services.

The top 10 holdings as of December 31 were UnitedHealth Group (UNH) 6.21 percent, Eli Lilly (LLY) 5.54 percent, AstraZeneca (AZN) 5.37 percent, Pfizer (PFE) 4.50 percent, Merck (MRK) 4.14 percent, Novartis (NVS) 4.10 percent, Biogen (BIIB) 2.99 percent, Daiichi Sankyo (4568.JP) 2.90 percent, Stryker (SYK) 2.76 percent and Elevance (ELV) 2.70 percent.

VGHCX has a beta of 0.60 versus the 0.74 of the category and 0.67 of the index. The standard deviation is 15.54 versus 20.73 and 16.86 for the category and index, respectively. VGHCX is less volatile than the category and index and is also less volatile than VHT, which has a 0.68 beta and 16.92 standard deviation.

Performance

VGHCX has decreased 1.37 percent in 2022. That was 14 percentage points better than the category and 4 percentage points better than the index.

VGHCX has 3-, 5- and 10-year annualized returns of 6.83 percent, 9.74 percent and 12.64 percent.

It has outperformed the category over all of these periods, by 0.7 percentage points over 10 years and more than 2 percentage points annualized in the 3-year and 5-year periods.

VGHCX underperformed the index in the 3-, 5- and 10-year periods by an annualized 2, 1.4 and 0.8 percentage points, respectively.

Distributions

Over the past 5 years, the fund has paid dividends and capital gains equivalent to a minimum of 5.5 percent. Three years were above 8 percent and the highest was more than 12 percent in 2019. Investors should consider holding the fund in a tax-advantaged account.

Outlook

The strongest catalyst for healthcare is demographics. Most countries in North and South America, Europe, and Asia are rapidly aging. Healthcare demand rises as people age. Most countries are seeing their healthcare spending climb as a percentage of their economy. This will provide steady growth for the sector in both good and bad years for the overall economy.

Healthcare delivers a good defensive profile within a moderately weak stock market. Last year, investors rotated money from technology and growth into energy and value. This caused steep losses in technology and growth stocks, and indexes such as the S&P 500 Index were down close to 20 percent. Sectors without that exposure (including healthcare) saw small losses. Healthcare won’t offer much protection in a full-blown bear market where investors indiscriminately sell stocks, but even then, its losses might be meaningfully smaller than the broader markets. In the context of the current economy, technology and growth stocks are most at risk should inflation remain high, while energy and cyclicals stocks are most at risk should the Fed overdo it with rate hikes.

History tells us healthcare typically underperforms when investors are becoming aggressive and holds up better when they turn cautious. Slow and steady wins the race though. After last year’s pullback in growth stocks, healthcare is outperforming consumer discretionary and communication services over the past decade. Only technology has done better.

We recommend investors overweight healthcare stocks in most market conditions. VGHCX is a good option. Its higher international exposure offers some geographic diversification. Portfolios with heavy value exposure should check sector exposure to make sure healthcare isn’t too high a percentage of assets, but since the sector itself has lower volatility and steadier performance, a slightly high overweighting isn’t as worrisome as it would be in the energy sector, as one example.

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Long-term U.S. Treasury bonds suffered one of their worst years ever in 2022. The decline in the price of a 10-year Treasury bond was the worst since 1788, according to one bank’s research. Back then, the newly formed United States was saddled with high inflation stemming from funding the Revolutionary War. This time, the losses were mainly a consequence of an unsustainably high bond price caused by the Federal Reserve’s zero-percent interest rate policy.

Duration

Interest rate risk is a function of time and cash flow. The less cash flow, the higher the interest rate risk. The longer the time until maturity (return of principal), the higher the interest rate risk. Long-term, zero-coupon bonds have the highest interest rate risk, while high-yield, short-term bonds have the lowest. Bond funds are measured by their duration, calculated by factoring in both the cash flow and time until maturity. The longer the duration of a fund, the higher the interest rate risk.

Bond prices move up when yields fall, and they move down when yields rise. When the Federal Reserve pinned short-term rates at zero (again) in 2020, many bonds rallied strongly. Eventually, inflation was out of control and the central bank raised rates. Previously, the Fed hiked rates slowly because there was little consumer price inflation from 2011 to 2020. This time, the Federal Reserve waited far too long before hiking and had to rapidly raise rates back to “normal” levels. Bond prices tumbled in response.

Credit Risk

U.S. government bonds have only interest rate risk. Corporate bonds and riskier foreign countries have interest rate risk and credit risk. Last year saw a rise in credit risk, which peaked in June. Since then, it has been in a general downtrend. As long as the economy is growing, credit risk will remain low.

Peak Inflation

Entering 2023, long-term interest rates are on the decline. Consumer prices remain elevated and will continue rising, but the pace has slowed considerably. How much it slows will determine Federal Reserve policy. From July to December, the Consumer Price Index rose about 1 percent. If it continued at that pace for another six months, the Fed could declare victory. The Cleveland Fed thinks inflation will be in the range of about 4 percent, annualized, in the first quarter. If this scenario plays out, the Federal Reserve will hold interest rates higher for longer and may hike them even more.

If the Federal Reserve keeps rates high and economic growth is strong, investors in floating-rate and high-yield corporate securities will see better performance than long-term government bond holders will. Fidelity Strategic Income (FADMX) is a great option, with its experienced multimanager team covering all manner of fixed-income segments and keeping an eye on higher-yielding securities.

Fidelity Strategic Income has 11 managers. The lead managers are Ford O’Neil and Adam Kramer, who have 10 and six years with this fund, respectively. O’Neil has more than 30 years of experience with Fidelity and has managed Total Bond (FBNDX) for nearly 20 years. Kramer has been with Fidelity for 22 years. The other managers all specialize in various credit sectors, including foreign bonds. Lead managers set the fund’s allocation in each credit class, and the other managers focus on security selection.

FADMX yields 5.74 percent. It has an expense ratio of 0.66 percent. There is no investment minimum. The fund has earned a four-star and a Silver rating from Morningstar.

The fund’s default allocation is as follows: junk bonds 40 percent, investment grade 30 percent, emerging markets 15 percent, developed markets 10 percent and floating rate 5 percent. Roughly speaking, the fund’s base allocation has 60 percent of assets in what would normally be higher-risk, higher-yielding debt and the remaining 40 percent in investment-grade bonds or sovereign debt.

Portfolio

FADMX currently has 41 percent of assets in junk bonds; of those, 34 percent are corporate bonds. There is nearly 3 percent in equity, rights and warrants; 2 percent in cash; and 2 percent in bank loans.

Floating-rate debt is currently underweight, at approximately 8 percent of assets. U.S. government debt is nearly 30 percent; of that, 27 percent is government bonds and 3 percent securitized debt.

Developed market debt is 5 percent, split almost evenly between sovereign and corporate debt. Emerging market debt is nearly 16 percent of assets, with 11 percent in sovereign debt, 4 percent in corporate bonds and the rest in floating rate and cash.

Geographic exposure is heavily weighted in the U.S., with 81 percent of assets. Canada, Germany, Mexico, the United Kingdom and Israel each have more than 1 percent of assets and combine for about 7 percent.

As for credit quality, U.S. government bonds are 29 percent, AAA through A is 6 percent, BBB is 18 percent, BB is 18 percent and B is 23 percent. Nearly 4 percent is CCC and below, while 12 percent has no rating. Almost 100 percent of the fund—to be precise, 99.87 percent—is in U.S. dollar-denominated debt as of December 31.

The weighted average maturity of bonds is 15.60 years, but the duration is only 4.45 years, thanks to the high yield on many of the bonds. For every percentage point decline or increase in interest rates, we’d expect FADMX to rise or fall about 4.45 percent, respectively.

FADMX has a beta of 0.98 and a standard deviation of 8.59, making it more highly correlated with the Bloomberg Aggregate Bond Index but slightly less volatile, despite having much more credit risk than the average multisector bond fund.

Performance

FADMX fell 11.13 percent last year. The five-year U.S. Treasury bond rose from 1.2 percent to 4.0 percent on the year. Given the fund’s duration of 4.45, we’d expect the fund would lose about 12.46 percent; thus, it performed about as expected with respect to the decline in price.

FADMX has a 3-year annualized return of 0.66 percent. This compares with negative 0.35 percent for the category and negative 1.97 percent for the index. It has been a volatile period for bonds, but FADMX has bested the competition.

Income

Dividends are paid monthly. They have fluctuated between 3.6 cents per month and 2.1 cents over the past three years. Dividends trended up with yields in 2022, but investors can’t be sure that rates will stay high. Retired investors looking for spendable income should budget on the low side of that range. On the bright side, that low included the 2020-2021 period, when the Fed slashed the fed funds rate to zero. Capital gains were 20 cents in 2021 and 15 cents in 2020.

Outlook

FADMX offers investors a diversified portfolio backed by Fidelity’s deep manager and analyst pool. Including all the subsector managers who also manage other funds at Fidelity, there are 11 managers providing guidance for this portfolio. While many areas of the market have become dominated by passive investing, credit analysis provides a critical edge for bond investors. Buying the bonds with the largest market share, for example, might mean buying bonds of companies with the largest debt. Most of the time, it doesn’t matter, because the bond markets function smoothly. In March 2020 though, FADMX outperformed iShares iBoxx High Yield Corporate Bond (HYG) by 7 percentage points. In short, high-yield bonds are one of the asset classes where active management provides the greatest value.

As for interest rates and credit risk, the current environment favors higher-than-expected interest rates, falling-but-still-elevated inflation and better-than-expected economic growth (assuming most of the market was buying into all the recession chatter the past two months). This is a good environment for high-yield bonds because long-term bond yields should fall with disinflation, but the fund’s higher-yielding short-term debt will benefit from the Fed keeping short-term rates elevated. Even if longer-term rates go higher this year, there’s no evidence to suggest rates will rise nearly as much as they did last year. This will limit the downside from interest rate risk. Stable economic growth will keep a lid on credit risk.

Finally, after a brutal 2022, some investors have cut back on bond allocations. However, in the wake of such a negative year, the outlook for a diversified portfolio of bonds has improved. Short-term bonds, for example, went from a near 0 percent yield to 4 percent now. Many investors aim for a long-term total portfolio return in the range of 6 to 8 percent. The rise in interest rates has greatly aided investors in reaching their targets with less risk and lower volatility than equities come with.

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