The Sector-Neutral Value ETF

Most value funds tend to overweight certain sectors such as financial services and energy, and underweight others, like technology. Investors who prefer to avoid large sector bets against the market might consider iShares MSCI USA Value Factor VLUE. It tracks an index that targets the cheapest stocks in each sector (representing around 30% of the market) and sets its sector weightings equal to the broad market-cap-weighted MSCI USA Index's. Stocks are weighted according to both their market-capitalization and the strength of their value characteristics, rescaled to maintain sector neutrality. This approach allows the fund to maintain a deeper value tilt than many of its market-cap-weighted value index peers, despite having greater exposure to traditional growth industries. It charges a competitive 0.15% expense ratio and is one of the more compelling options for exposure to large-value stocks.

In contrast to traditional value indexes, this fund's benchmark assesses each stock's value characteristics relative to its sector peers. This puts stocks from different sectors on a level playing field. For example, a stock in the technology sector that looks cheap relative to its sector peers could make the cut, while an energy stock with even lower absolute valuations might not (if it is more expensive relative to its peers). Valuations may be more comparable within the same industry than across industries, which may give the fund cleaner exposure to stocks that are truly cheap relative to their peers.

The fund's sector-neutral approach may 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.

In September, 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 to limit sector tilts. The enhanced-value index strengthened the fund's value orientation because it targets a smaller subset of the market than the index it replaced.

Fundamental View Value stocks have historically outperformed their growth counterparts in nearly every market studied over long time horizons. From its inception at the end of 1974 through September 2015, the MSCI USA Value Index outpaced the MSCI USA Growth Index by 81 basis points annualized. This performance gap has been more pronounced among more-exaggerated value and growth portfolios and smaller-cap stocks. Because more investors are aware of this effect and are trying to take advantage of it, it may be smaller in the future. However, this premium will likely persist.

Investors may require higher expected returns to own value stocks, which have less attractive business prospects than their growth counterparts and could be riskier. Value stocks tend to be less profitable, grow more slowly, and are less likely to enjoy sustainable competitive advantages than growth stocks. 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.

This fund should offer investors a better way to take advantage of the value effect than most market-cap-weighted value index funds. It offers greater exposure to the cheapest stocks in each sector by targeting a smaller segment of the market than many of its index peers and incorporating the strength of each stock's sector relative value characteristics in its weighting approach. This should give it an edge when value stocks are in favor. The fund also factors market capitalization into its weightings. This reduces its exposure to stocks with poor recent performance (which often continue to underperform) and prevents it from loading up on the smallest stocks in its selection universe. Pure market-cap-weighted alternatives skew toward the biggest value stocks, not necessarily the cheapest.

The fund's sector-neutral approach works against its value tilt by causing it to overweight more-expensive sectors than traditional value indexes. Over the long term, sector-level performance tends to mean-revert, so beaten-down sectors may offer higher expected returns that traditional value index funds can better capitalize on. However, at the end of September, the fund's holdings were trading at lower average multiples of forward earnings (12.7) and book value (1.6) than the MSCI USA Value Index (15.3 and 1.9, respectively). They also have a higher expected earnings-growth rate.

Because this fund isn't paired with a growth index, it 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.

From its back-tested inception in December 1997 through September 2015, the fund's benchmark outpaced the market-cap-weighted MSCI USA Value Index by 3.1 percentage points annualized, with greater volatility. While the fund may not offer such a large performance edge going forward, it has a reasonable chance to outperform.

Portfolio Construction The fund employs full replication to track the MSCI USA Enhanced Value Index, which selects large- and mid-cap stocks from the MSCI USA Index. MSCI assigns sector-relative value scores to each stock in the MSCI USA 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 around 30% 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 a set of buffering rules to mitigate turnover. As a result, stocks are allowed to stay in the index even after they fall a bit outside its targeted value range. Similarly, new additions must rank in the top half of the index's targeted value range in order to make the cut. MSCI also moderates changes in portfolio weightings at rebalancing by applying a 50% haircut to the desired weighting change.

Alternatives

There are plenty of low-cost alternatives to choose from, including

Investors looking for a more exaggerated value tilt might consider

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