SMLF: Mostly Mid-Cap, Rather Volatile Mix, Only A Hold

seekingalpha2023-12-19

SMLF offers a sophisticated, multi-factor take on the small-cap echelon.SMLF has a too-short trading history with a new index in place and too-large exposure to loss-making companies that renders its ...

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It is far from being a purely small-cap portfolio, as illustrated by its weighted-average market cap.SMLF's return since the index change was mostly strong by SMID echelon standards, but it nonetheless lagged the market badly.The expense ratio is extraordinarily low, assuming the complexities of the strategy. But this alone is not enough for a Buy rating.   Shutter2U Today, I would like to discuss the iShares U.S. Small-Cap Equity Factor ETF (NYSEARCA:SMLF), a passively managed vehicle leveraging a sophisticated multi-step small-caps-focused strategy. I have reviewed a few multi-factor and factor rotation strategies in the past, including the WisdomTree U.S. Multifactor Fund (USMF), BlackRock U.S. Equity Factor Rotation ETF (DYNF), and Invesco Russell 1000 Dynamic Multifactor ETF (OMFL). Only the latter earned a Buy rating from me, while DYNF and USMF did not convince me. Neither did SMLF. As a factor analysis devotee, I like when funds do something unconventional chasing returns, i.e., create peculiar factor combinations that should give them an edge over other market participants. In the case of SMLF, even despite the sophisticated approach of its underlying index looking promising, the return it has delivered since the index change is not convincing enough, while the current portfolio composition leaves a lot to be desired, especially for quality-focused investors or those who are on the lookout for pure small-cap exposure. That is to say, I see little to no support for a well-rounded bullish thesis, so SMLF earns only a Hold rating today. Investment strategy basics Launched in April 2015, as mentioned in the prospectus, SMLF has changed its investment strategy in March this year, now tracking the STOXX U.S. Small-Cap Equity Factor Index instead of the MSCI USA Small Cap Diversified Multiple-Factor Index. It was subsequently renamed. Thus, I will ignore the performance delivered prior to that. On the SMLF website, it is said that the index is  composed of U.S. small-capitalization stocks that have favorable exposure to target style factors subject to constraints. The prospectus provides more details. More specifically, constituents are selected from the STOXX US Small Cap Index. There is \"an optimization process designed to maximize exposure to four target factors: momentum, quality, value, and low volatility.\" It is also said that \"carbon emissions intensity and greenhouse gas (“GHG”) reduction targets\" are included in the quality score (please refer to page S-2 of the prospectus). The index is \"reviewed and rebalanced\" on a quarterly basis. Addressing the factor story Under the hood, there is a rather volatile, mostly mid-cap mix with a few quality issues. I have arrived at this conclusion after dissecting its portfolio as of December 14 using methods I regularly apply in my ETF research. Below is the table containing the essential factor parameters that I suppose deserve a more attentive review.       Metric 14-Dec   Market Cap (weighted-average) $6.229 billion   Market Cap (median) $3.442 billion   EY 2.25%   P/S 6.38   EPS Fwd 8.46%   Revenue Fwd 7.54%   ROE 11.47%   ROA 3.23%   Quant Valuation B- or better 26.6%   Quant Profitability B- or better 65.6%   24M Beta 1.13   60M Beta 1.25   Click to enlarge Created using data from Seeking Alpha and the fund; financial data as of December 16 SMLF is overweight in mid-caps The first fact is that regardless of the methodology used to assess the size factor, it seems the fund's portfolio is dominated by mid-caps, as illustrated by both weighted average and median figures. More specifically, I have analyzed 832 companies out of the total of 859 holdings (as of December 14; the latter figure includes swaps, futures, a money market fund, etc., which I have not taken into account). The essential finding was that the fund has a footprint in the small-cap universe, even with a few micro-caps in the basket (about 40 bps weight). Nevertheless, while 16.5% of the net assets are allocated to large caps like Builders FirstSource (BLDR), which was valued at $20.8 billion as of December 16, and about 66.4% were allocated to medium-sized companies, it is questionable whether small-cap investors should consider it at all. Value exposure could have been better Next, I do not see much value exposure in this basket, though there is no dramatic overvaluation as well. One of the issues here is that measuring SMLF's value characteristics is complicated. For instance, the meaningful presence of biotechnology names with microscopic revenues and thus four-digit and triple-digit Price/Sales resulted in a portfolio-wise multiple of 6.38x. I suppose it should not be treated as an indication of SMLF's valuation issues, as it is skewed. As for the earnings yield, which is also frequently used for funds with meaningful allocations to financials (about 16.8%), the following scatter plot should answer the question regarding why the weighted-average figure is again close to useless here.   Created using data from Seeking Alpha and the fund This is the dispersion of the EYs of the SMLF holdings. And it is vast. The problem is that numerous outliers with deeply negative earnings render it almost completely irrelevant, so we have to search for more creative ways to address that problem. One of the solutions, though not an ideal one, which I have already applied in the past, is to replace all the negative EYs with zero. In this case, SMLF's EY stands at 5.76%. This might look like a value territory already if compared to about 4.3% EY of the market. Still, the iShares Core S&P Small-Cap ETF (IJR) offers an EY of around 8% (based on its P/E of 12.36x as of December 14), so SMLF looks comparatively more expensive. Overall, I believe a more reliable way is to look at the Quant Valuation ratings. SMLF has slightly more than a quarter of its net assets allocated to relatively undervalued names (a B- grade or better), while 44% look comparatively overpriced (D+ or worse). Since there are indications that the market is now switching to a value-agnostic regime, I do not view this as a primary concern, while I also see no justification for a Buy rating on that front as well. Quality and growth exposures It is not coincidental that just around 65.6% of the holdings have a B- Quant Profitability rating or higher. The size factor is the top culprit here, as SMID companies tend to lag their larger counterparts when it comes to profitability and capital efficiency. Speaking of capital efficiency, it will not be an exaggeration to say that both weighted-average Return on Equity and Return on Assets are distorted, as almost a fifth of the companies are unprofitable. A few debt-heavy outliers with overinflated (and thus unreliable) ROE, like Tempur Sealy International (TPX) and Insperity (NSP) also contributed. Nevertheless, ROA, even if calculated as a median with all negative figures removed, stands at just 2.7%. ROE, computed in a similar fashion, is at 10%. Both figures are unquestionably bleak. On the growth front, there is not much to discuss, as my calculations show both forward revenue and EPS growth rates in the high single-digits. This is a healthy result, but obviously not great. Momentum and volatility Inside the SMLF portfolio, there are a few negative surprises for volatility-averse investors. More specifically, my calculations show that both the 24-month and 60-month weighted-average beta coefficients are well above 1, which indicates that overall, in the current iteration, the portfolio should be more volatile than the market. As for momentum, just about 56% of the holdings have the eponymous Quant grade of B- or better. Performance: mostly robust, but not much data available To assess how successful the fund has been since the index change, I would like to compare its returns to the results delivered by the two groups of ETFs. The first one consists of small-cap funds. In the second one, multi-factor and factor rotation funds were included. In both cases, the iShares Core S&P 500 ETF (IVV) was added for better context. Let us look at the first group. The period in focus is March 2–December 18. Price return (Seeking Alpha) From the chart above, we can tell that SMLF did excellently, delivering a stronger price return than the iShares Core S&P Small-Cap ETF (IJR), the WisdomTree U.S. SmallCap Dividend Fund ETF (DES), and the Schwab U.S. Small-Cap ETF (SCHA). Alas, it was unable to keep pace with the market. The total return chart tells a similar story. Total return (Seeking Alpha) Now let us look at the second group: Price return (Seeking Alpha) Here, SMLF's strategy looks much less potent as it failed to deliver a higher return than the following funds I covered in the past: DYNF, USMF, and OMFL. On the positive side, SMLF outperformed the Invesco S&P SmallCap 600 QVM Multi-factor ETF (QVMS), with both price and total returns being a few percentage points higher. Total return (Seeking Alpha) Investor takeaway  To conclude, SMLF has a too-short trading history with a new index in place and too-large exposure to loss-making and EBIT-negative companies that renders its traditionally calculated EY, as well as ROE and even ROA, irrelevant. Its overall quality is only average if measured using alternative techniques. Besides, the fund is far from being a purely small-cap portfolio, as illustrated by its weighted-average market cap. Its returns since the index change were mostly strong by SMID echelon standards, but it nonetheless lagged the market badly. Its expense ratio of 15 bps is extraordinarily low, assuming the complexities of the strategy. But this alone is not enough for a Buy rating.","kind":null,"is_publish_news":null,"is_publish_highlight":null,"is_publish_live":null,"is_publish_wemedia":null,"editions":null,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.22.4","shortVersion":"4.22.4","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2392861928"}