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Unloved ETFs

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Susan Dziubinski: I'm Susan Dziubinski with Morningstar. U.S. large-cap growth stocks have largely been market darlings. Joining me today to discuss some ETF ideas that are maybe in some less popular categories is Ben Johnson. Ben is Morningstar's global director of ETF research.

Hi, Ben. Thank you for being here today.

Ben Johnson: Hi, Susan. Thanks for having me.

Dziubinski: Now, one certainly less popular area of the market has been U.S. small-value stocks. Can you talk a little bit about why they've been less popular and have been underperforming?

Johnson: Well, in a word, it's performance, and in two words, it's been really lousy performance. I guess, that's three words. But over the course of the past decade, what we've seen is that the Morningstar U.S. Large Growth index has gained 17% annually. Over that same span, the Morningstar U.S. Small Value index is up just 8% a year. And that spread has really only widened in recent years. So, if we look back just over the past three years, the large growth index is up 22% a year, while the small value index has been up about 1% a year.

Now, for a long stretch of time, that was perfectly justifiable. What we saw was that the fundamentals, the earnings growth in those larger, faster-growing stocks, more than justified their multiples. Meanwhile, the earnings, the fundamentals of those small-value names languished. That three-year figure that I referred to--the 22% annualized versus the 1% annualized--that spread, that wedge we've seen more recently, has been driven not by fundamentals, not really been justified, but almost exclusively by multiple expansion. We've seen the multiples of many of the market's darlings, names like Tesla, get up to absolutely stratospheric levels. And that really has explained much of what we've seen in this spread between the large-growth and the small-value segments over recent years.

Dziubinski: Given that underperformance, Ben, how have investors responded?

Johnson: Many investors have cried uncle. So, I summed up all of the flows in the Morningstar small value category across active and passive funds, ETFs and mutual funds. And what we've seen is that those funds have been in outflows for the past four years running. In total, investors have pulled $9 billion in their hard-earned capital from those funds over the course of the past four years.

Dziubinski: For investors who might want to play a rebound in small value, what ETFs do you like in that corner of the market?

Johnson: Our favorite ETF in the small value Morningstar Category is the Vanguard Small-Cap Value ETF. The ticker for that one is (VBR). This is a no-frills approach to getting exposure to this segment of the market. It's a broadly diversified, market-cap-weighted index fund that charges a rock-bottom fee. Its annual expense ratio is just 0.07%. It's backed by a sound steward of capital in Vanguard, and it earns a Morningstar Analyst Rating of Gold.

Dziubinski: Now, Ben, looking abroad, emerging markets haven't been embraced. Why is that? What's the story there?

Johnson: Well, in the same three words I shared earlier, Susan, it really boils down to really lousy performance. What we've seen is that over the course of the past 10 years, emerging markets on whole have lagged--and lagged most significantly U.S. stocks and most notably U.S. large-cap stocks. So, over the course of the past decade, the annualized return of the S&P 500 index has been more than triple that of the MSCI Emerging Markets Index. And what we've seen is that in recent days, many investors have decided that they're not going to stick around to sit this out, try to see if things are going to improve. And what we saw in 2020 is that across all funds in the diversified emerging-markets Morningstar Category, they witnessed their first year of outflows since 2015.

Dziubinski: In this particular part of the market, emerging markets, what's a favorite ETF of ours there?

Johnson: What I would say is that, while we have a generally dimmer view of broad-based market-cap-weighted indexing in emerging markets--given that that method of constructing a portfolio tends to result in some notable concentration risks, most notably, a fairly significant allocation to Chinese stocks, many of which are state-owned enterprises, which don't necessarily always operate with the best interest of shareholders in mind--it still doesn't do much to diminish the appeal of broad diversification, low turnover, and very low fees. So, ticking all three of those boxes is one of our favorites in the category, which is the iShares Core MSCI Emerging Markets ETF. The ticker for that one is (IEMG). Casts a very wide net, sweeping up most of the investable market capitalization within that opportunity set, charges a very low fee, is helmed by a great team that's very savvy when it comes to index portfolio management, and should do well for investors over a very long period of time.

Dziubinski: Ben, thank you for your time today and for sharing some of these highly rated ideas in these unloved categories. We appreciate it.

Johnson: Thanks again for having me, Susan.

Dziubinski: I'm Susan Dziubinski. Thank you for tuning in.

Ben Johnson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.

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