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By Alex Bryan | 10-22-2015 06:00 AM

This ETF Takes a Different Approach to Value

IShares MSCI USA Value Factor ETF eliminates the unintended sector biases that value-focused index funds often have.

Alex Bryan: Most traditional market-cap-weighted value indexes tend to overweight certain sectors like utilities, financial services, and energy stocks. These sector tilts can, of course, affect performance in the short term; but they may be unintended bets. So, investors who are concerned about taking these types of sector bets might consider a fund like iShares MSCI USA Value Factor ETF (VLUE).

This fund effectively targets the cheapest 30% of stocks in each sector, but it applies sector-neutral weightings, which means that it sets its sector weightings equal to the market-cap-weighted MSCI USA Index. What that does is it minimizes these types of unintended bets and homes in on the stocks that are the cheapest relative to their peers.

The way that it looks for value or assesses value is it looks for stocks that are cheap relative to other stocks in the sector based on price/forward earnings, price/book, and enterprise value relative to cash flow from operations. That last metric accounts for differences in leverage that can affect the other two valuation metrics.

On its semiannual rebalancing dates, this fund sets its sector weightings equal to the market-cap-weighted benchmark and rescales the weightings of the holdings in each of the sectors to achieve that objective. So, effectively, what this does is it eliminates unintended sector tilts and biases and really isolates the exposure to the value effect.

Now, there are some drawbacks to this approach. One, it can potentially increase turnover when you reset back to those sector weightings twice a year. That's a potential cost to investors.  Additionally, the sector-neutral approach allows the market to dictate what the sector weightings are going to be. So, if a certain sector like technology is overvalued, this fund will have greater exposure to that sector than its traditional value index peers. However, overall, it's a really compelling option for investors who do want to minimize those unintended sector bets. It charges a very reasonable 15-basis-point expense ratio, so that makes it a very compelling option, overall, for investors who want exposure to value stocks.

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