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Deep Value in the S&P 500 Index

This fund offers a heavy dose of value, but it may overweight companies with deteriorating fundamentals. 

Alex Bryan, 05/09/2014

Most value index funds target the cheaper half of the market, which tends to sweep in a large helping of blend stocks that dilute their value tilts. In contrast, Guggenheim S&P 500 Pure Value RPV targets the cheapest third of the S&P 500 Index and weights its holdings by the strength of their value characteristics. This style purity allows investors to add a value tilt to a diversified portfolio with a smaller investment in this fund than its peers would require.

This approach has generated attractive returns. Over the trailing 10 years through April 2014, the fund's S&P 500 Pure Value Index benchmark outpaced the market-cap-weighted S&P 500 Value Index, which tracks the cheaper half of the S&P 500 Index, by 4.6% annualized. However, part of this performance gap may be due to differences in market capitalization. Because the pure value index does not weight its holdings by market cap, it tends to have a smaller-cap tilt. For instance, the average market cap of its holdings ($19.6 billion) is currently only a fraction of the corresponding figure for the S&P 500 Value Index ($70.1 billion). During the past decade, the S&P 500 Pure Value Index outpaced the Russell Midcap Value Index by a more modest, but still respectable, 1.2% annualized.

Value stocks have historically outperformed their growth counterparts in nearly every market studied over long time horizons. Because of its deeper value tilt, RPV may be able to capture this premium more effectively than its peers. Its disciplined rebalancing approach also helps. When it rebalances annually in December, the fund increases its exposure to stocks that have become cheaper relative to their peers and trims its exposure to stocks that have become more expensive. These disciplined bets against the market may allow RPV to more effectively capture the mean reversion behind the value effect. However, they may also cause it to overweight stocks with deteriorating fundamentals, which can increase risk.

The S&P 500 Pure Value Index was about 33% more volatile than the Russell Midcap Value Index over the past decade. It has also tended to underperform during market downturns. In 2008, it lagged the Russell Midcap Value and S&P 500 Value Indexes by 9.4% and 8.7%, respectively. However, this fund may be a suitable satellite holding for investors with a strong risk tolerance.  

Fundamental View 
In the United States, large- and mid-cap value stocks have outpaced their growth counterparts by approximately 2.5% annualized from 1927 through 2013, according to data from the French Data Library. Efficient-market advocates argue that this performance gap is compensation for risk. This risk story is plausible. Value stocks tend to have less attractive business prospects than their growth counterparts, which may justify their lower valuations. They are also less likely to enjoy sustainable competitive advantages. Many of the fund's holdings, such as StaplesSPLS and Hewlett-Packard HPQ, face significant competitive pressures that could limit their profitability and growth.

On average, RPV's holdings generated a lower return on invested capital--5.5% over the trailing 12 months through April 2014--than Guggenheim S&P 500 Pure Growth's RPG holdings (13.3%). Not surprisingly, they have also been growing at a much slower clip. Analysts expect this gap to narrow but continue during the next five years, according to consensus estimates collected by Morningstar. Investors may demand higher expected returns to hold these less desirable companies.

Yet, investors may penalize these value stocks too much by extrapolating recent performance too far into the future. This myopic focus can push prices below their fair values. Consequently, value stocks have generated better risk-adjusted returns than the market over the long run. Their depressed valuations can provide a margin of safety and attractive upside if they exceed expectations, which are low to begin with.

But because they often face dim business prospects, value stocks can be difficult to own. Some of these companies may look cheap, but become cheaper as their fundamentals deteriorate. That's enough to make many investors nervous. Even if these stocks are in fact undervalued, they can remain out of favor for years. This makes it difficult to eliminate the value premium through arbitrage. Consequently, it likely will persist.

Alex Bryan is an ETF analyst with Morningstar.

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