The Small Cap Growth style ranks ninth out of the twelve fund styles as detailed in my Style Rankings for ETFs and Mutual Funds report. It gets my Dangerous rating, which is based on aggregation of ratings of 11 ETFs and 437 mutual funds in the Small Cap Growth style as of January 30, 2014. Prior reports on the best & worst ETFs and mutual funds in every sector and style are here.

Figure 1 ranks from best to worst the nine small-cap growth ETFs that meet our liquidity standards and Figure 2 shows the five best and worst-rated small-cap growth mutual funds. Not all Small Cap Growth style ETFs and mutual funds are created the same. The number of holdings varies widely (from 27 to 1705), which creates drastically different investment implications and ratings. The best ETFs and mutual funds allocate more value to Attractive-or-better-rated stocks than the worst, which allocate too much value to Neutral-or-worse-rated stocks.

To identify the best and avoid the worst ETFs and mutual funds within the Small Cap Growth style, investors need a predictive rating based on (1) stocks ratings of the holdings and (2) the all-in expenses of each ETF and mutual fund. Investors need not rely on backward-looking ratings. My fund rating methodology is detailed here.

Investors should not buy any Small Cap Growth ETFs or mutual funds because none get an Attractive-or-better rating. If you must have exposure to this style, you should buy a basket of Attractive-or-better rated stocks and avoid paying undeserved fund fees. Active management has a long history of not paying off.

Get my ratings on all ETFs and mutual funds in this style by searching for Small Cap Growth on my free mutual fund and ETF screener.

Figure 1: ETFs with the Best & Worst Ratings

Screen shot 2014-02-05 at 11.47.03 AM* Best ETFs exclude ETFs with TNAs less than $100 million for inadequate liquidity.

Sources: New Constructs, LLC and company filings

Vanguard S&P Small-Cap 600 Growth ETF (VIOG) and PowerShares RAFI Fundamental Pure Small Growth Portfolio (PXSG) are excluded from Figure 1 because their total net assets (TNA) are below $100 million and do not meet our liquidity standards.

Figure 2: Mutual Funds with the Best & Worst Ratings – Top 5

Screen shot 2014-02-05 at 11.46.23 AM* Best mutual funds exclude funds with TNAs less than $100 million for inadequate liquidity.

Sources: New Constructs, LLC and company filings

Oak Associates Funds: River Oak Discovery Fund (RIVSX) is excluded from Figure 2 because its total net assets (TNA) are below $100 million and do not meet our liquidity standards.

iShares S&P Small-Cap 600 Growth ETF (IJT)is my top-rated Small Cap Growth ETF and Virtus Equity Trust: Virtus Small-Cap Core Fund (PKSFX)is my top-rated Small Cap Growth mutual fund. IJT eanrs my Dangerous rating and PKSFX earns my Neutral rating.

Vanguard Small-Cap Growth ETF (VBK) is my worst-rated Small Cap Growth ETF and Wells Fargo Funds Trust: Wells Fargo Adv Traditional SmCap Gro Fd (EGWAX) is my worst-rated Small Cap Growth mutual fund. VBK earns my Dangerous rating and earns my Very Dangerous rating.

Figure 3 shows that 169 out of the 1963 stocks (over 6% of the market value) in Small Cap Growth ETFs and mutual funds get an Attractive-or-better rating. However, no Small Cap Growth ETFs or mutual funds get an Attractive-or-better rating.

The takeaways are: mutual fund managers allocate too much capital to low-quality stocks and Small Cap Growth ETFs hold poor quality stocks.

Figure 3: Small Cap Growth Style Landscape For ETFs, Mutual Funds & Stocks

Screen shot 2014-02-05 at 11.45.26 AMSources: New Constructs, LLC and company filings

As detailed in “Low-Cost Funds Dupe Investors”, the fund industry offers many cheap funds but very few funds with high-quality stocks, or with what I call good portfolio management.

Investors need to tread carefully when considering Small Cap Growth ETFs and mutual funds, as there are numerous Dangerous-or-worse rated funds. No ETFs or mutual funds in the Small Cap Growth style allocate enough value to Attractive-or-better-rated stocks to earn an Attractive rating. Investors should focus on individual stocks instead.

Assurant Inc. (AIZ) is one of my favorite stocks held by Small Cap Growth ETFs and mutual funds and earns my Very Attractive rating. Over the past eight years, AIZ has grown after-tax profits (NOPAT) by 6% compounded annually and currently earns a return on invested capital (ROIC) of 11%. Even better, AIZ has generated positive economic earnings every year since 2004. The company has increased economic earnings by 26% compounded annually during this timeframe. While AIZ’s fundamentals are sound, the valuation makes his an especially appealing stock. At ~$64/share, AIZ has a price to economic book value (PEBV) ratio of 0.75. This ratio implies the market expects AIZ’s NOPAT to permanently decline by 25%. Since AIZ managed growth over the past eight years even with the financial crisis, such a pessimistic expectation seems unwarranted.

Concur Technologies, Inc. (CNQR) is one of my least favorite stocks held by Small Cap Growth ETFs and mutual funds and earns my Dangerous rating. Over the past eight years, CNQR’s after-tax profit (NOPAT) has declined by 20% compounded annually. The company currently earns a bottom quintile return on invested capital (ROIC) of 0% and has generated negative economic earnings in 14 of the past 15 years. Despite this heady decline in profits, the stock is up 86% over the past year. The disconnect between stock price and profits has led to the stock being dangerously overvalued. To justify its valuation of ~$124/share, CNQR would have to grow NOPAT by 29% compounded annually for the next 46 years. This level of growth in a technology company may be possible over a short time frame, but to be sustained for such an extended period of time is almost impossible. CNQR operates in a niche market of travel expense management, and I can’t see demand growing enough for the entire industry, much less CNQR’s share of it, to meet the expectations embedded in its valuation.

Figures 4 and 5 show the rating landscape of all Small Cap Growth ETFs and mutual funds.

My Style Rankings for ETFs and Mutual Funds report ranks all styles and highlights those that offer the best investments.

Figure 4: Separating the Best ETFs From the Worst Funds

SCGF4Sources: New Constructs, LLC and company filings

Figure 5: Separating the Best Mutual Funds From the Worst Funds

SCGF5Sources: New Constructs, LLC and company filings

Review my full list of ratings and rankings along with reports on all 11 ETFs and 437 mutual funds in the Small Cap Growth style.

Kyle Guske II contributed to this report.

Disclosure: David Trainer and Kyle Guske II receive no compensation to write about any specific stock, sector, style or theme.

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