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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.

Alex Bryan is an ETF analyst with Morningstar.

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