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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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