AVUV vs VTSAX: Why Small Cap Value Could Outperform

25:11Mindy Jensen:Oh, it's not. It is technically called an actively managed fund, but that's not a reasonable way to describe it, right? I would describe this as an algorithmic fund, which is the way I would describe all index funds. There are no people sitting around a table picking these stocks. It's basically, they've created an index of categorizations. They run a computer program on it, and it picks the stocks for them. It works exactly like VTSAX or VOO, just using a different index or categorization method. There's no magical people sitting there picking things and hoping to get lucky, and maybe get lucky sometimes or not.

25:49I view them as an index fund. The distinction you really need to draw when you're looking at something like this is, do we have people around a table picking stocks and putting them into this fund? That is an actively managed fund. That's human management. What we're talking about here is an algorithm run by a computer. It's the difference between somebody pushing a broom and a Roomba.

26:10Mindy Jensen:Well, that's a great analogy. I like that a lot. So what is the expense ratio for AVUV? Do you know off the top of your head? It's about 0.2 or 0.25, somewhere around there. And I would not compare that to something like VTSAX. I would more compare it to those three basic small cap value funds that I talked about. So the Russell IWN fund typically performs like 2 % worse than something like AVUV. You are getting more bang for your buck. And this is why people were willing to pay financial advisors for this. It wasn't cheap to go to Paul Merriman's firm and get DFA funds back in the day. You were paying 1 % to Paul Merriman's firm and you were paying more than that just to get access to this fund because it was that much better.

27:00So the way you should look at it is you don't have to pay over 1 % to get access to a fund like this. You're now paying 0.2%. And so you're getting even more than you would have back in 2010 when this became a popular thing amongst financial advisors.

27:19Mindy Jensen:I like that you explained that because you might not compare it, this 0.2 or 0.25 to VTSAX, but I've got listeners who will. And I like that you explained you're getting a better return. Past performance is not indicative of future gains. This is not financial advice, blah, blah, blah, all the disclaimers. But AVUV is my second highest performer. Now I'm going to go back into my other investments and look and see where I can maybe make some tweaks to include AVUV in other portfolios that I have. This is it's the only one I have it in right now is my Frankonomics portfolio that you helped me set up.

27:56I would not compare it for just six months. So I would go back and you can find that DFA small cap value fund that goes back to 1993. And if you compare that to the S &P 500 or VTSAX, you'll see that that fund has outperformed since that time. Actually, since the beginning of the millennium. But they performed differently at different times. So if you look at, say, the past 10 or 15 years, the large cap funds have outperformed. They've done much better. Large cap growth has been the place to be. But if you go back to the early 2000s, those big companies, you know, crashed, you know, 40 percent, 50 percent between 2000 and 2003.

28:33And your small cap value companies were either going up or flat at that time. Yeah, I remember that crash. Same thing happened in 2022. I think AVUV was down 5 percent, where the S &P 500 was down 25 percent or something like that. That's really what we're talking about here. We're not looking really for what do we think is going to outperform in the near future or something like that. What we really care about is, is this going to perform at least as well as the rest of the stock market? And is it going to perform differently than something else I have? Because that's the reason to hold more than one thing when it comes down to it.

29:08Frank, if I'm thinking about small cap value, right, like I can't help but kind of just conjecture. Like this is how I work in all of my life, right? What does fictional perfection potentially look like? And then how do I refine that hypothesis based on additional assumptions, right? So if I'm thinking about a small cap value fund that to me intuitively would perform really well with reasonably stable returns, I'd think about first, of course, price to earnings ratios. I'd think about a certain size dynamic. I'd think about, you know, no extreme leverage, right? You can have a great price to earnings ratio, but if you have 20 times your earnings in debt, that's not a good sign.

29:44That's not really the thesis that we're betting on. If you have some kind of recurring revenue and your deferred revenue balance is falling dramatically or, you know, that that is different than a company that is growing deferred revenue very rapidly, which is almost certain to hit the price to earnings multiple downstream. Right. Growth profiles are the amount of capital intensity of the business is going to make it make a difference as well. Those are some of the dynamics we can argue about some of them. Maybe extreme leverage should be included because an average amplifies returns. Right. Like there's an argument there.

30:14But those are like the starting points I'd have for small cap value and what I would be intuitively thinking I'm investing in. Can you reassure me that funds like an AVUV have some of those components in place, even if they disagree with the premise potentially of some of the other ones that I just stated? Yeah, I mean, and you can and should look at the components of whatever fund you're investing in. If you go to a place like Morningstar, it's the easiest place to get a feel. You put your fund in there and then click on the portfolio thing, and it gives you all these data points, including the top 25 companies in the fund.

30:49And then it also gives you the sector breakout. So you'll find that small cap value has a lot of financials in it, which are essentially small banks and insurance companies and things like that and other, you know, small manufacturers and industrial companies. It's the kind of businesses that, you know, Cody Sanchez and Alex Hormozzi talk about buying, right? Like the HVAC business. Yeah, storage facilities and dry cleaner type. Yeah, what they don't tell you about the HVAC and the garage door business is how hot and cold or up and down it can get. That's the kind of stuff that they're going for.

31:20That's the sort of thing. And there are usually a couple of thousand companies in each one of these funds. So they're really well diversified. In some respects, they're much more better diversified than like a VTSAX or a S &P 500 because they don't have the same kind of concentration. If you look at the top 25 companies in a small cap value fund, that's not going to be 80 % of the fund. Whereas if you look at VTSAX right now, I think the top seven or 10 companies are like 40 % of the fund. So it's actually more diversified when you get to these smaller funds than a large cap fund.

31:59Mindy Jensen:Can you explain why VTSAX has those top companies taking up 40 % of the fund? It's all in the algorithm. The algorithm used for VTSAX tells you to take all the companies, but then arrange them by size and put more money in the biggest ones. The bigger they are, the more you own of it. As certain things become bigger, you buy more of it. In a sense, it's kind of a momentum fund. The better something is doing. That's why NVIDIA went from a very small part of VTSAX to now, maybe it's the largest company in there. I don't know. It's close to it. But that's why you get this big concentration at the top.

32:38And that's also why all of these large cap funds tend to be the same. They're all investing in the same things and in large proportions. So whether you took an S &P 500 fund or a large cap growth fund or VTSAX, there's a huge overlap there. They're basically investing largely in the same things. But it all has to do with the algorithm, again, that is used to set up the fund. This is kind of a tangent here, but one of the things that I've been very worried about, you will be, I'm sure, pushed back on this, but I think that that concentration in the S &P 500 or in any major index around market cap weighting is especially dangerous right now because of the AI dynamics.

33:24When we talk about, for example, in 2026, there's an estimated$600 billion that's going to be invested in AI specifically, most of that in chips. Those chips depreciate, essentially become obsolete after about 18 to 24 months as the next generation cycles through. So that's capitalized and does not offset earnings for these companies in that year, and it's depreciated for five or six years. However, I believe that realistically, 80 to 85 % of that spend should be expensed in the year. That changes the forward price to earnings multiple or the past price to earnings multiple pretty dramatically, that single change in terms of how you view, how you think that accounting should treat AI investment in the markets here.

34:10This is a tangent again, but any reaction to that observation at a high level from your view in terms of how that would change or tweak or influence anything related to investing? Well, I think if you look at the history of stock market and see how this goes, I mean, there are parallels. We've seen this kind of a movie before, and it generally occurs when the stock market has been doing well over a long period of time. And that is often connected to some kind of new technology, whether it's railroads or the Internet or something else. What happens is the largest companies grow a lot. The people get excited about them.

34:47They put more into them. That increases the concentration at the upper ends of these index funds, these large cap index funds that are cap weighted. And so then sometimes it crashes. I mean, I don't have any disagreement with what you said technically, but I'm just telling you sort of my view of this is, you know, this movie has happened before and we know we know how it ends, but it doesn't necessarily end that way. But let's think about what if it does end badly? Because this happened in the early 1970s with something called the Nifty 50, Xerox, Polaroid. That was a time when everybody was saying, these 50 companies are the bee's knees and just put your money into them.

35:26Don't worry about the valuations. You can't lose. And people did lose. The major consequence in the 1970s, the reason the stock market stayed down as long as it did, was because these Nifty 50 companies crashed and didn't recover. The same thing happened in the dot-com era. So you had all of these companies. Unfortunately, the ones today, the difference people point out today is, well, at least they're profitable today. The ones we were talking about in the 1990s weren't profitable and people were throwing all kinds of money into them. But you got the same results. These things grew up. They got really big.

35:57And then there was a crash. In both cases, holding value stocks saved you. That's the lesson. That if you held value stocks in the 1970s, small cap value or even large cap value, the small cap value companies went up every year from 1975 to 1987, while these large cap nifty fifties were, you know, down in the dumps and having all kinds of problems. Same thing happened in the early 2000s. The total market indexes and the big tech companies and everything crashed. when the NASDAQ went down 80 % and the S &P 500 went down 40 or 50%. If you had value companies, they either didn't go down much or they actually went up.

36:36The lesson here is not to worry about trying to forecast this or is this like before or is this not like before? I would rather say, I don't know, but I won't put all my eggs in that basket. I will put some of my eggs in this value basket because I know that if that crashes, this one's probably going to do a lot better and I'm going to be better overall and I'll be a lot safer and happier. I love it. I find this so fascinating because, you know, I just invested in the S &P 500 for, I don't know, 10, 12, 15 years as my only stock exposure, essentially, for the entirety of my accumulation phase and only really thought about this towards the very end when I was transitioning to like, OK, I'm going to actually start living off a little bit of the portfolio that I've built here now.

37:16This discussion, I think if I had understood all of this when I started, I would have almost certainly mixed it up and had some, you know, S &P 500, some value component to my growth portfolio. And then maybe some international split between those two as well, between international blood and international value as well. And there, but at least those two dynamics in that growth journey. And the irony there is that if I had, if I had known this and done that, I'd be less wealthy than I am today because small cap value underperformed the S &P 500 during that time horizon. Right. And that, like, that's the fun thing about investing here is like the more you're like, you can know all this extra stuff and get more sophisticated.

37:53And then it's like even worse than the other alternatives because it's just so unpredictable. You can only know in hindsight what was the best combination of funds to hold in the last period. The key is just let's invest in low cost funds that are 100 percent in equities when we're accumulating and just keep putting in money and figure the rest of this out later because it doesn't matter as much until you're pulling money out. And you can't predict which combination of a few index funds is going to be better than another one in the next 10 or 20 years. You just can't. So the key there is just don't put your money in target date funds.

38:28They have bonds and other weird things in them. Just get your index funds and put your money in there and leave it alone. There is a convenience factor, Scott, in terms of, yeah, if you would have known this, you know, 20 years ago and you did half small cap value and half large cap growth or something like that, then it would have been easier to transition into a diversified retirement portfolio. But not doing that, it doesn't kill you that much, particularly since a lot of people have these things in their retirement accounts anyway, and there's no taxes and you can just sell one thing and buy another one.

39:03That's right. If my gains had been smaller, I'd pay less taxes. Frank, you're absolutely right.

39:06Mindy Jensen:I need a DeLorean with a flux capacitor. I guess this leads to the next question, right? Like, you know, the coffee is, the S &P 500, right? That's your black coffee. You got to mix in the creamer, which is going to be your value. The right creamer makes a big difference. And if you're not putting hazelnut in your coffee, you're doing it wrong, metaphorically here. So is that in play to the next discussion ought to be how we sweeten the coffee in terms of like stevia or sugar or one of these sweetener alternatives? And that's where international comes in? Or am I reaching way too far now into our coffee analogy?

39:40You're probably reaching too far into the coffee.

39:44Mindy Jensen:My international has been good, but not as good as gold. So sweeten it with gold, Scott. Well, gold is an international asset, too. That's the reason. Oh, OK. I don't even think of it as domestic or international. I'm, you know, frank. Americans just think everything is about them. It's a good thing my father's from another country. The international that you put me in is also Avantis. Yeah, well, that's because you can now buy small cap value in the international flavor or large cap growth in an international flavor. That's what's so nice and what has developed over the past eight years or not.

40:22These things were hard to find and they probably cost a lot more money than they do now. But now that we do have DFA and Avantis both putting out reasonably priced ETFs that cover these different asset classes or subclasses is really what they are. There's a lot more choices that we have. And, you know, 20 years ago, we didn't have these choices. We just you had to pay an advisor to get even close to access to them. So we need to take advantage of the modern iPhone here and go out there and take a look at these things. And you mentioned Paul Merriman. He's got his little team there, and they actually review all of these funds and do a categorization.

41:02And they published it on their website saying these are the best in class. If you're looking for an international small cap value, try one of these. If you're looking for U.S. small cap value or large cap value, try this one. In a sense, if you're just looking for a fund, they've done that work for you. That's where I would go if somebody says, I want a mid-cap growth fund. And I'd go in there and say, which ones look good? because they'll list all the basic index funds plus some of these more advanced things. I want to summarize kind of where I'm at here, right? We have great research that discusses the advantages of splitting a portfolio out like this and in essence, weighting much more heavily than a broad-based market cap weighted index fund would to small cap value.

41:43So that's the first pillar here. The second is that there are varying degrees of complexity about how to weight to small cap value. And we have from the very simplistic in the Russell 2000 or the S &P 600 small cap index and to increasing levels of sophistication with some of these more algorithmic funds here. I still don't think we know exactly what the thesis is for AVUV specifically. There may even be a proprietary element to it. It was not available in a way I could understand very clearly, like what those hard rules are on the Morningstar website. I did actually look that up before our call here.

42:24And I can't really find, I still can't explain why it's different than a very close peer fundamentally, even though I know I have seen Paul Merriman's site say, hey, here's the edge here. It's very close between these two, but we prefer this one for this reason. And so I think that's kind of the next layer of depth I would love to get to over time is like, no, no, actually, specifically, what is it that AVUV is doing? I think that's the third leg of this conversation or this study that they'll have to do in the coming weeks here to say, no, that's exactly what these are the rules that you're investing in.

42:55And here's where you can debate with them. You know, I think reasonable people can disagree on where certain cutoffs should be in value. But those will matter over time. Those will separate performance across these funds in ways you probably can't predict. Is that the right takeaway to have from today's conversation, Frank? Well, if you want to do that research, you can do it. And that's what Paul Merriman and his team have done. If you go to someplace like Portfolio Visualizer, there is an analyzer that will break funds down by how big or small they are, how valuey they are, how much momentum they have in them.

43:27They will basically categorize them by factor. And so you can look and see which of the small cap value funds is the most valuey or the smallest or has these other characteristics. And so you can do that research and see some of that. What you can't see is the kind of profitability or quality factor that AV, UV or DFA is actually applying because that is their proprietary way of constructing the fund. But they do describe that in the text. If you look at the prospectus, basically, we're taking the basic small cap value and then applying these other filters to essentially get rid of bad companies is basically what's going on there.

44:09So it's not it's not magical, but it's not. No, you cannot find the AV UV index posted somewhere. Fair enough. Yeah. Because then Vanguard could create one. Well, Frank, this has been absolutely phenomenal and very educational as always here. I have one last question before we go, which is how do you like your coffee? Black. Me too. Yeah. Same here.

44:31Mindy Jensen:Wait, I thought you liked it with hazel that I was going to say, Scott, you're doing it right. You're both doing it wrong. Once in a blue moon, I'll put some hazel nut creamer in there. But no, I always drink it black. I will have a cappuccino like when I'm on vacation or something. But on a day-to-day basis, you know, I'm a black coffee chugger. I do put a little bit of cinnamon on the top of the beans. And that adds a nice little spice to the coffee. Just a little bit. That's a pretty nice touch if you've ever tried that. Sounds wonderful. Well, hey, thank you so much for coming on today. Coming back on again, Frank.

45:02Really appreciate it. And yeah, can you remind everybody where people can find out more about you? Oh, yes. I run a podcast called Risk Parity Radio, where all finer podcasts are sold. Plus, we have a website. And I had a volunteer nicely fix the website. So it's now actually searchable for stuff like this if you want to go in there and find because there's 500 episodes or almost 500 episodes of the podcast. I do want to plug my podcast is a retirement hobby and it's not for profit. But we do raise money for charities. And we usually raise money for my charity, which is called the Father McKenna Center.

45:35But starting tomorrow and the next couple of months, we are raising money for my wife's charity because she reads the emails and she works for Fairfax Casa, which is Court Appointed Special Advocates. So these are volunteers who assist with children who have been removed from the home and they're in a foster situation until they go through the court process and figure out whether they're going back to their parents or getting adopted or something else like that. What are the two web URLs or best ways that people can remember to donate to one or both of these charities? I put this in the show notes at my podcast, and it's going to be on the support page.

46:12I think that's the easiest place for somebody to look. But it's Fairfax County Court Appointed Special Advocates. That's a mouthful. In Virginia is hers. And the Father McKenna Center, M-C-K-E-N-N-A, in Washington, D.C., is the one that I'm affiliated with. Awesome. People should go and check out your show. If many people will not take all that stuff, we'll link to both of those in the show notes here. And you can Google them just so you know that you're aware, even if you don't actually go on to listen to Frank's show, which you should to find those charities. It's great work that you're doing there.

46:48And thank you for all you're doing for the personal finance community and for the folks in your community locally. Well, thank you. I enjoy this.

46:56Mindy Jensen:Frank, it was great to talk to you. Thank you so much for your time. And we'll talk to you soon. OK, great. All right, Scott, that was Frank Vasquez. And I mean, what do we say to follow up Frank? He knows everything. Go listen to his podcast and contribute to his charities. I think the answer is that Frank is a real master on these macro allocation theory items here. And, you know, alongside folks like Paul Merriman. And we still don't really know what it is specifically that differentiates AVUV from its peer set and its alternatives in there. And there's a little bit of a trust implication in there if that's a specific ETF.

47:32So I don't think we can specifically recommend AVUV. And I think we can only specifically recommend going down this rabbit hole of understanding why folks argue for small cap value and then how to define it and how to add it to your portfolio, the reasons it makes sense to you. So that's a rabbit hole I want to continue to go down. I am a nerd. I want to understand at the mechanical level everything that I'm putting my money into. And I still don't right now when it comes to AVUV, even if I, to some degree, implicitly trust the research that backs small cap value in the first place.

48:04Mindy Jensen:I have AVUV in one of my portfolios, in my Frankonomics portfolio, and I like the way it's been performing. So yeah, it's time for a deeper dive into past performance, which is not indicative of future gain, blah, blah, blah. But past performance is a good place to look. It's a good place to start. So I am going to dive down that rabbit hole and maybe start making some more allocations. But yes, this is not financial advice. This is just information. So you can do with it as you please. Thank you for listening. All right, Scott, should we get out of here? Let's do it. That wraps up this episode of the BiggerPocketsMoney podcast.

48:40Mindy Jensen:He is Scott Trench. I am Mindy Jensen saying see you, Chia. See you later. Latte. See you, Latte. No, see you, Chia. That was really cute. Yes, but we'll also see you, Latte. if you put hazelnut in it. Scott, if you don't put hazelnut in it, you're just wrong. That's right. If you've been putting off life insurance, I get it. The old process was miserable. Phone calls with an agent, a nurse coming to your house for a blood draw, then waiting weeks to find out what you'd pay for. That friction is exactly why so many people who should have coverage don't. Here's what I believe. Most BP money listeners need term life, and the right move is to build a ladder.

49:14A few term policies of different lengths stack together so your coverage steps down as your mortgage shrinks and your kids get closer to being financially independent or you get closer to hitting your financial independence number. The thing that makes that practical now is Ethos, a platform that helps you find life insurance all 100 % online. Same day coverage, no medical exam. You just answer a few health questions online, up to$3 million in coverage, some policies as low as$30 a month. So building a two or three layer ladder that used to take a month of appointments is something you can knock out before your coffee gets cold.

49:46Get your free quote at ethos.com slash bpmoney. That is E-T-H-O-S dot com slash bpmoney. Application times may vary and rates may vary. There's a certain set of challenges that come after the financial ones are mostly solved. Questions about what comes next, how to think about the life you're building around your wealth, not just the wealth itself. Most people find that they don't have anyone to talk to about that part. James Keefe spent 20 years in pharmaceuticals building toward that stage. When he found Long Angle's community, something specific resonated. Here's what he said. It's a community of primarily first-generation wealth builders.

50:19We all feel like we've gone through some sort of rite of passage. You'll end trust a little sooner with that. It's clearly a group of people that also care about you as a person. Long Angle is a vetted community of 8 ,000 plus entrepreneurs, executives, and investors, mostly self-made, all navigating the same complexity on both sides of the financial equation. Membership is free for those who qualify. Apply at longangle.com slash money. That's longangle.com slash money.