FNDA: A Solid Small-Cap ETF (NYSEARCA:FNDA)

Introduction

This article covers the Schwab Fundamental U.S. Small Company Index ETF (NYSEARCA:FNDA) (the “Fund“), a passively managed exchange-traded fund (“ETF“) managed by Charles Schwab Investment Management, Inc. (the “Fund Sponsor“). Awarded three-stars from Morningstar, the Fund boasts a low expense ratio (0.25%) and above-average relative performance. Notably, the Fund does not stand out compared to my favorite small-cap ETF, the Pacer US Small Cap Cash Cows 100 ETF (CALF) (“CALF“), although it does match up well with the Vanguard Small-Cap Growth Index Fund ETF (VBK) (“VBK“) (another small-cap ETF that I own).

Overall, while the Fund is solid, and I deem it a BUY, CALF, which I would consider a STRONG BUY, is likely a better option for investors seeking small-cap exposure.

Why Small Caps?

While I have been slowly increasing my portfolio’s allocation to small-cap stocks, I am still very underweight the category. Of course, small caps have been underperforming for several years, as is shown in the table below comparing the Fund, the S&P 500, and the Russell 2000 (using the iShares Russell 2000 ETF (IWM) (“IWM“) as a proxy for the Russell 2000) over a five-year period ending April 9, 2024.

Valuation

Underperformance of small caps could mean opportunity, and the Fund has notably outperformed IWM over the five-year period. The table below shows that small caps historically trade at 6% discount to large cap stocks; however, at the beginning of 2024, that discount was above 30%.

Source: Voya Investment Management

Moreover, according to Morningstar, key valuation metrics of the Fund compared to the S&P 500 (as expressed by the ticker SPY, the SPDR S&P 500 Trust) and CALF are shown below (as of April 11, 2024).

Click to enlarge

The data clearly show that the Fund is much cheaper than S&P 500, and this valuation discount will have to narrow over time in my view (unless capitalism is broken). Notably, on three of the four valuation metrics, CALF is even cheaper than the Fund.

Given how cheap small caps are relative to large caps, I have acquired several small-cap positions, and have moved some money in my retirement accounts to a small-cap growth mutual fund.

I have continued to research small cap exchange-traded funds (“ETFs“), looking to diversify into a few different investments. In this regard, I have recently been looking at the Fund, which has successfully garnered more than $8 billion in assets since its August 15, 2013 inception date.

The Fund

Per its Prospectus, the Fund generally invests in stocks that are included in the Russell RAFI US Small Company Index (the “Index“). Specifically, the Prospectus provides that:

The Index selects, ranks, and weights securities by fundamental measures of company size – adjusted sales, retained operating cash flow, and dividends plus buybacks – rather than market capitalization. The index measures the performance of the small company size segment by fundamental overall company scores (scores). . . . Securities are grouped in order of decreasing score and each company receives a weight based on its percentage of the total scores of the U.S. companies within the parent index. The index is comprised of the smallest U.S. companies by fundamental size. The bottom 12.5% of the companies by cumulative fundamental score are included in the index. The weights of the companies included in the index are determined annually and are implemented using a partial quarterly reconstitution methodology in which the index is split into four equalsegments and each segment is rebalanced on a rolling quarterly basis.”

The Index is crafted by the Frank Russell Company and Research Affiliates LLC. While the fund is a passive vehicle, the investment advisor does have some discretion. According to the Prospectus:

[W]hen the investment adviser believes it is in the best interest of the fund, such as to avoid purchasing odd-lots (i.e., purchasing less than the usual number of shares traded for a security), for tax considerations, or to address liquidity considerations with respect to a stock, the investment adviser may cause the fund’s weighting of a stock to be more or less than the index’s weighting of the stock. The fund may sell securities that arerepresented in the index in anticipation of their removal from theindex, or buy securities that are not yet represented in the index inanticipation of their addition to the index.”

Moreover, the Prospectus provides that the Fund is permitted to invest up to 10% of its net assets in securities not included in the Index. Notwithstanding the Fund’s discretionary authority, the Fund’s performance demonstrates that the Fund has done a respectable job of tracking the Index:

Click to enlarge

Pros of the Fund

The Fund definitively has some things going for it. For one, it is likely undervalued relative to large cap stocks, as shown in the chart above. Moreover, it has a low management fee and tracks its Index well. In addition, its fundamentals focus, which screens out some of the weaker companies of the Russell 2000, has seemed to work well over time as evidenced by the Fund outperforming IWM (see chart above).

See “Risks” below for certain “cons” of investing in the Fund.

Fund Holdings

The Fund’s top 10 holdings account for less than 4% of its total assets, and, as of April 10, 2024, those holdings were as follows (per the Fund’s website):

Click to enlarge

Notably, the largest position of the Fund, Coinbase Global (COIN), has a market cap of more than $55 billion (hardly a small-cap company). Similarly, Super Micro Computer (SMCI) has a market cap of above $50 billion and has been admitted to the S&P 500. It is interesting that the Fund has retained this position; the Fund’s investment parameters certainly permit it to do so.

With all of the top ten positions well below 1% of the Fund’s portfolio, it is hard for any single position to move the performance needle. Indeed, with over 1,000 holdings, the Fund is clearly very diversified, if not “over-diversified.”

Sector Composition & Weightings

The Fund is diversified across multiple sectors. Per its website, the top sectors at the end of 2023 were as follows:

Click to enlarge

The large exposure to Real Estate stands out to me, and I am not a fan. While Industrials should do well in an inflationary environment (including wars in Ukraine and Israel), the Fund’s allocation to the Energy and Materials sectors is not as robust as I would like.

Competitors

As shown earlier in this article, the Fund has outperformed IWO since its inception; however, I wanted to compare the Fund against two ETF competitors in the small-cap space which I own. Those two ETFs are CALF and VBK. As is shown below, the Fund has had mixed results against these two competitors. The Fund has trailed CALF during each relevant period of at least a year, while outperforming VBK in the 3 and 5-year periods, as shown in the charts below.

Extending the comparison, holdings, year-to-date performance, management fee and other information for the three ETFs is shown in the table below.

Click to enlarge

Source: Seeking Alpha, except that Morningstar rankings are from Morningstar (linked above).

Notwithstanding the management fee of the Fund being favorable relative to CALF, it is clear that CALF has performed very well over the last five years compared to the Fund. On the other hand, the Fund fares better compared to VBK, even with VBK’s lower management fee. With five stars, CALF clearly has the advantage over the other two ETFs as determined by Morningstar analysts.

As a growth fund, VBK is less of an apples to apples comparison with the Fund; however, CALF is clearly a direct competitor of the Fund.

Material differences between the Fund and CALF

Key differences between the Fund and CALF include:

1) As shown earlier in the article, CALF has outperformed the Fund over several time periods, from 1-Year to 5-Years.

2) CALF follows its passive index without the discretion that the Fund has, and CALF rebalances quarterly versus the Fund’s more unusual method (per the Prospectus):

The weights of the companies included in the index are determinedannually and are implemented using a partial quarterly reconstitutionmethodology in which the index is split into four equal segmentsand each segment is rebalanced on a rolling quarterly basis. [Emphasis supplied.]

3) CALF has been awarded 5-Stars by Morningstar’s analysts, compared to the Fund being awarded 3-Stars.

4) On certain key valuation metrics of price to cash flow, price to earnings and price to sales, CALF is less expensive than the Fund, which may provide an even greater upside and/or a greater margin of safety for CALF relative to the Fund. See the valuation metrics table earlier in the article.

5) CALF enjoys all of the above advantages even though its management fee is 34 basis points higher than the management fee of the Fund.

6) CALF’s portfolio is a lot more concentrated than the Fund, which, in my view, has proved to be a key advantage relative to CALF’s competitors (including the Fund and VBK).

Risks

The risks of investing in the Fund are set forth in the Prospectus (linked earlier). For me, however, the risks of the Fund are as follows:

1) Small Caps continue to underperform large caps because passive flows disproportionately flow to large caps.

2) The Fund is currently underweight certain sectors that historically do well in an inflationary environment, such as Energy and Materials.

3) The Fund is overweight Real Estate, which is not where I want to be. [Parenthetically, if I am going to invest in real estate at this juncture in the cycle, I want to do it with an active manager that only invests in real estate (i.e., a specialist). I do suspect that there are real estate stock bargains to be had in the current environment!]

4) There is a risk that the Fund will not adequately replicate the Index, particularly with its discretion as described above. This risk seems small, however, given how well the Fund Sponsor has tracked the Index over the long term.

Conclusion

The Fund successfully launched in 2013 and has over $8 billion in assets. At this time, the Fund is a BUY given its solid performance and its valuation discount relative to large caps; however, in my view and as this article has shown, there are better options in the small-cap space — namely, CALF (which I would consider a STRONG BUY).