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Value Investing In ETFs Requires Time

In the last decade, value investing has not worked very well, consistently underperforming growth. That performance is a reminder of just how cyclical factors can be, and how important time horizon is when you are trying to capture a risk premium.

Consider the performance of one of the largest value ETFs, the Vanguard Value Index Fund (VTV), relative to its growth counterpart, the Vanguard Growth Index Fund (VUG), in the past 10 years:

If you are a value investor, you probably know this well: “At its core, value is an uncomfortable trade,” John West, of Research Affiliates, told an audience of investors, advisors and asset managers at the Morningstar Investment Conference in Chicago this week.

The pain comes from buying cheap in the hopes of capturing upside, but running the risk that the cheap will get far cheaper before they recover. It’s hard to hold on to your conviction when you are wondering if what you own isn’t a value play but a value trap.

To that end, fund sponsors and asset managers look at all sorts of value metrics, combining various approaches in search of a true value portfolio. In the ETF market, that effort translates into 50 value ETFs, with no two alike.

Top Heavy In Assets

The leader, the iShares Russell 1000 Value ETF (IWD), with $37 billion in assets, commands nearly 25% of all assets in value ETFs today. This is a pocket of the ETF universe that’s top heavy in terms of assets—the three biggest ETFs, all targeting U.S. large-cap value, command more than $80 billion in assets, which is more than the total assets in the remaining 46 ETFs combined.

They are:

On the surface, these three funds aren’t all that different, but they offer a glimpse into how you can tackle value through slightly different approaches even when going rather vanilla.

Price-To-Book Metric

IWD uses a multifactor approach both for stock selection and weighting, picking from U.S. stocks ranked 1-1,000 by market cap based on various style factors. The fund looks for companies that are undervalued relative to “comparable” companies by looking at value metrics such as price-to-book.

From a sector perspective, IWD allocates most heavily to financials and energy, at about 31% and 12%. The 682 holdings have a weighted average market cap of about $120 billion. The portfolio’s price-to-book ratio is 2.03, and its price-to-earnings is 26.5—the highest among the three.

VTV, with $30 billion in assets, selects stocks from the top 85% of market capitalization based on multiple value factors. It too is a multifactor approach, but one that results in a slightly different portfolio.

Financials and industrial names lead the portfolio’s sector exposure, at 25% and 12%, respectively. The 315 holdings—about half the number of securities as found in IWD—have a higher weighted average market cap than IWD, of about $148 billion. The portfolio’s price-to-book ratio is 2.27, and the price to earnings ratio is 22.4—the lowest among the three.

Fundamental Approach

IVE uses a fundamental approach to picking stocks, which it then weights by market capitalization. The portfolio chooses value stocks from the S&P 500 Index only, and has 351 holdings with a weighted average market cap of $125 billion. The price-to-book ratio of the portfolio is 2.06, while price-to-earnings is 22.73. From a sector perspective, financials also lead, with 28%, but it’s consumer cyclicals that follow, with a 12% allocation.

All of these ETFs are hugely liquid, and very popular with investors, but their portfolios are all slightly different, leading to similar—but not equal—performances. Look at their returns in the past 12 months (compared with growth fund VUG):

Charts courtesy of StockCharts.com

Core Quant Approaches

Beyond these ETFs, there are many others, some taking core quant approaches to finding value. A perfect example of that is the First Trust Large Cap Value AlphaDex Fund (FTA) or even the PowerShares Dynamic Large Cap Value Portfolio (PWV), among others.

FTA, with $1 billion in assets and an expense ratio of 0.62%, selects and weights value stocks from the S&P 500 Value Index using fundamental factors including sales, book value and cash flows. The stocks are then equally weighted, but within five tiers. With 187 holdings, FTA has lower price-to-book and price-to-earning than the biggest three ETFs—1.9 and 17, respectively.

PWV, with $1.26 billion in assets and an ER of 0.57%, has a portfolio that’s among the smallest in this space—only 50 holdings. Price-to-book of the portfolio is 2.18, and price-to-earnings 15.85. PWV is as multifactor as they come, picking holdings using a 10-factor style isolation process, and then using a tiered weighting scheme.

At the end of the day, the takeaway here is the following: Experts like West, or AQR’s Ronen Israel argue that it’s hard to say one value metric is better than another. Each of these ETFs goes about searching for value in various ways, and each has a good case behind its approach.

Value Here To Stay

But value isn’t going away. What makes value investing work goes well beyond security selection.

First, it’s about the realization that value is a risk premium—it doesn’t work all the time. West pointed out that a look back in history shows that value underperforms about 15-20% of the time over 10-year cycles.

The fundamental drivers of value, however, aren’t going away even if value as a factor has been underperforming.

The key, they say, is time horizon. Capturing value is best done with a long-term time horizon as a strategic decision in a portfolio. It’s a buy-and-hold approach. Short-term approaches to value investing amount to nothing more than performance chasing, and ultimately, return losses. That means value investing requires commitment.

Finally, what makes it all work is regular rebalancing. You have to regularly sell the winners and add to the cheapest stocks in the portfolio, Israel says—buying low and selling high.

“We believe in the long-term efficacy of the equity market, and it’s not unusual to have periods when the stock market is down 10 years,” Israel noted. “I believe in value the same way.”

For a complete look at all value ETFs on the market today, check out our Value ETFs channel.

Contact Cinthia Murphy at cmurphy@etf.com

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