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The Sector-Neutral Value ETF

This fund allows investors to own cheap stocks without the persistent sector bets that most of its peers make.

Alex Bryan, 07/21/2017

Most value index funds have persistent sector biases, overweighting the financial-services and energy sectors, while underweighting technology and healthcare. Such sector bets are a source of active risk, but Morningstar research suggests that they aren't necessary for a value strategy to be successful. IShares Edge MSCI USA Value Factor ETF VLUE matches the market's sector weightings to eliminate this source of unintended risk and targets the cheapest stocks within each sector. This approach should give the fund cleaner exposure to stocks that are truly cheap relative to their peers. The fund's strong value-orientation and low fee build on this advantage. But it does take greater risk than most of its peers, which coupled with its short record tracking its current index, limits the Morningstar Analyst Rating to Bronze.

Sector-relative valuation screening puts stocks from different sectors on a level playing field. As a result, the fund avoids the persistent sector tilts characteristic of the large-value Morningstar Category average. Despite having greater exposure to more richly valued sectors, the fund has a stronger value orientation than most of its peers. That's because it applies a demanding sector-relative valuation screen and weights its holdings according to both their market capitalization and the strength of their value characteristics, rescaled to maintain sector neutrality. The fund's holdings currently represent just under 25% of its selection universe (the MSCI USA Index), which includes most large- and mid-cap U.S. stocks.

This strategy can help investors mitigate unintended bets, but there are some drawbacks. It allows the market to dictate the fund's sector weightings. So, if a sector is richly valued, this fund will have greater exposure to it than its market-cap-weighted value index peers. Similarly, it doesn't take a stand on beaten-down sectors, allowing their weightings to decline with the market's appetite for them. Rebalancing back to sector-neutral weightings also requires greater turnover than allowing them to float, which can increase transaction costs. However, the fund's benchmark applies turnover buffer rules to address this issue.

In September 2015, BlackRock switched the fund's benchmark from the MSCI USA Value Weighted Index to the MSCI USA Enhanced Value Index in an attempt to offer a more consistent exposure to value stocks and limit sector tilts. It has not yet established a meaningful record tracking this index.

Fundamental View 
Value stocks have historically outperformed their growth counterparts in nearly every market studied over long time horizons. Investors may require higher expected returns to own value stocks, which have less-attractive business prospects than their growth counterparts and could be riskier. But they could become undervalued if investors extrapolate past growth--or lack thereof--too far into the future. This can create systematic mispricing that may have contributed to value stocks' historical return advantage. Yet even if these stocks are undervalued, they can remain out of favor for years. This means that low valuations do not translate into easy profits. Because more investors are aware of the value effect and are trying to take advantage of it, it will likely be smaller in the future, but it should persist.

The fund should benefit more than most of its peers when value stocks outperform because it has a more exaggerated value tilt. And it is less dependent on the performance of traditional value sectors, like financial services, utilities, and energy. Morningstar research suggests that while sector-level performance has tended to mean-revert over the long term, value-driven sector tilts are active bets that are not well rewarded. By eliminating these sector tilts, the fund may help investors avoid unintentional bets.

Unlike most value index funds, which are paired with growth indexes, this strategy doesn't use low growth as a value signal. In practice, growth and valuations are highly correlated, but this is an incremental improvement. As an added benefit, its sector-relative value-screening approach improves comparability, though it may also increase risk because stocks that are cheap relative to their peers tend to have worse prospects. 

The fund's strong value tilt is partially attributable to its weighting approach, which incorporates the strength of each stock's sector-relative value characteristics. The danger with weighting stocks in this way is that it could increase the fund's exposure to stocks with poor momentum. However, the fund partially offsets this by taking market capitalization into account. This also prevents it from loading up on the smallest stocks in its selection universe. The fund has only a slightly smaller market-cap orientation than the Russell 1000 Value Index. Its portfolio is fairly well diversified, though the top 10 holdings currently represent about 37% of the portfolio. These include well-known, mature firms, such as Cisco CSCOIntel INTC, and Pfizer PFE.

From its back-tested inception at the end of November 1997 through May 2017, the fund's benchmark outpaced the market-cap-weighted MSCI USA Value Index by 2.8 percentage points annualized, with greater volatility and market sensitivity (beta). While the fund may not offer such a large performance edge going forward, it has a reasonable chance to outperform--particularly during bull markets.

Portfolio Construction
The fund warrants a Positive Process Pillar rating because it applies demanding sector-relative value selection criteria. This approach improves comparability and largely isolates the fund's active risk to its value tilt.

This strategy employs full replication to track the MSCI USA Enhanced Value Index, which selects cheap stocks from each sector in the MSCI USA Index. MSCI assigns sector-relative value scores to each stock in the parent index based on price/book, price/forward earnings, and enterprise value/operating cash flow (though it doesn't apply this last metric to the financial-services sector). The third metric strips out leverage--which can affect the other two ratios. MSCI then selects the top-scoring stocks until it reaches a predetermined target number of securities, representing between 20% and 40% of the parent index's market capitalization. Stocks that make the cut are weighted according to both the strength of their value characteristics and their market capitalization. MSCI rescales these weightings to match the sector weightings of the MSCI USA Index on the semiannual index reconstitution dates. This adjustment can increase turnover.

However, MSCI applies buffer rules that partially offset this effect. These rules allow stocks to stay in the index even after they fall a bit outside its targeted value range. MSCI also moderates changes in portfolio weightings at rebalancing by applying a 50% haircut to the desired weighting change.

Fees
The fund charges a low 0.15% expense ratio, which is only slightly higher than the cheapest market-cap-weighted alternatives. Therefore, it earns a Positive Price Pillar rating. BlackRock engages in securities lending, the practice of lending out the portfolio's holdings in exchange for a fee. This ancillary income partially offsets the fund's expenses. That said, over the trailing 12 months through June 2017, the fund lagged its benchmark by 27 basis points annually.

Alternatives
There are several low-cost market-cap-weighted alternatives, including Schwab U.S. Large-Cap Value ETF SCHV (0.04% expense ratio) and Vanguard Value ETF VTV(0.06% expense ratio). Both of these funds target stocks representing the cheaper half of the U.S. large-cap market, apply generous buffering rules to mitigate turnover, and earn a Morningstar Analyst Rating of Silver. They will likely continue to exhibit lower volatility than VLUE's index because they have a less pronounced value tilt and don't seek out the cheapest names in each sector, which tend to be riskier than average. 

Guggenheim S&P 500 Pure Value ETF RPV (0.35% expense ratio) has an even stronger value orientation than VLUE. It applies even more-demanding value-selection criteria and weights its holdings according to the strength of their value characteristics. While this weighting approach gives RPV a deeper value tilt, it may also give the fund greater exposure to stocks with deteriorating fundamentals. RPV does not make any sector-relative adjustments to its selection criteria. 

Bronze-rated Schwab Fundamental U.S. Large Company ETF FNDX (0.25% expense ratio) offers an alternative way to tilt toward value. It weights its holdings on fundamental measures of size, including sales (adjusted for leverage), retained operating cash flow, and dividends plus share buybacks. When FNDX rebalances, it increases its exposure to stocks that have become cheaper relative to these metrics and trims positions in stocks that have become more expensive.

  

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Alex Bryan is an ETF analyst with Morningstar.

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