Value funds have taken a drubbing for a decade. Will they ever recover? Perhaps. But the exchange-traded-fund industry is betting that traditional value strategies need tweaking.
Growth stocks (those from companies whose earnings are growing faster than the market’s average) have trounced value, returning on average an additional three percentage points every year over the past decade. Disruption from the likes of Amazon.com (AMZN) created a minefield of value traps, producing challenges from which companies might not recover. And the most common metric to gauge value—price-to-book value—has lost relevance as companies become more digital and services-oriented, and own fewer tangible assets, such as plants and equipment. Then there’s the makeup of indexes themselves: Compared with its value counterpart, the Russell 1000 Growth index (.RLG) owns three times as many technology stocks, which have led the bull market, and less than half of the financials, which have struggled over a decade of incredibly low interest rates.
ETF providers have responded with products that don’t define value using the standard metrics, and incorporate criteria used by active managers. These funds tend to have bigger allocations to tech stocks, and less of traditional value fare like financials and energy. A popular strategy mixes value with quality, focusing on companies with the financial wherewithal and sound business to get through the current rough patch.
The $5.5 billion Invesco FTSE RAFI US 1000 ETF (PRF), a fundamental index popularized by Research Affiliates founder Robert Arnott, is one of the earliest ETFs with a value quality tilt. The fund uses metrics like book value, dividends, sales, and cash flow to systematically rebalance by buying the cheapest stocks. The fund is up 15% this year, compared with a 13% return for the more traditional, and cheaper, $48 billion Vanguard Value Index (VTV). The Invesco ETF has also fared better over a decade, though it has trailed by roughly one percentage point over three- and five-year periods.
The $3.5 billion iShares Edge MSCI USA Value Factor (VLUE) looks for value within each sector, rather than across the market. That ensures greater sector representation, and mitigates the heavy sector bets inherent in classic value investing, says Alex Bryan, director of passive strategies research at Morningstar. Technology accounts for nearly a quarter of assets—double the Morningstar category average—and the fund has just under 20% of assets in financial and energy stocks, though they make up almost a third for the category. The ETF’s 12% average annual return over the past three years puts it in the top 15% of performers.
Tiny $105 million Alpha Architect U.S. Quant Value ETF (QVAL) is one of the more notable rethinks of value, says Dave Nadig, managing director of ETF.com. The fund, which charges a relatively high 0.49%, uses operating-profits-to-enterprise-value to gauge value, but its concentration sets it apart. After screening out companies at risk of financial distress or manipulation, and settling on the highest-quality businesses in financial and operational strength, the exchange-traded fund is left with 45 stocks in a portfolio, with less than 3% in financials, more than half of its assets in consumer-discretionary stocks, and 16% in technology.
But even founder Wesley Gray cautions that performance can be erratic and the ETF isn’t intended for investors with short-term horizons. Gray also warns that value investors’ tough stretch could continue: “No number of Ph.Ds and fancying things up can fix that problem.”
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