Cheap Exposure to Mid-Cap Value Stocks

Value stocks tend to have less-attractive business prospects than their faster-growing counterparts, so they are not necessarily bargains. But they may offer compensation for their risk over the long term. They could also become undervalued if investors extrapolate past growth--or lack thereof--too far into the future. Historically, value stocks have outpaced their growth counterparts in nearly every market studied over the long term. This effect has been most pronounced among small-cap stocks and smallest among large caps. While small-cap value stocks may offer greater upside potential, mid-cap stocks are generally a little less risky.

Because this fund covers approximately half the mid-cap market, it includes some stocks with modest value characteristics. These holdings help limit the fund's exposure to distressed companies and may reduce volatility. Despite its broad reach, the fund has less overlap with its growth counterpart,

Low fees give the fund a sustainable edge against its peers. Since its inception in August 2006, the fund outpaced the mid-value category average by 1.2 percentage points annualized, with similar volatility. As an added benefit, its benchmark (which it has tracked since April 2013) applies generous buffering rules to limit turnover.

Fundamental View Mid-value stocks have a decent long-term record. From its inception at the end of 1985 through October 2015, the Russell Midcap Value Index (which is similar to this fund's benchmark) outpaced the Russell Midcap Growth Index by 1.1 percentage points annualized. Investors may demand higher expected returns to own value stocks, which have less-attractive business prospects than their growth counterparts and could be riskier. On average, the fund's holdings generated a lower return on invested capital (8.1%) than those in VOT (12.6%) over the trailing 12 months through October 2015, indicating that they are less profitable. During the next five years, analysts expect these holdings to grow earnings 8.9% annually and those in the growth fund to grow at 12.9%, according to consensus estimates presented in Morningstar Direct.

Despite these characteristics, value stocks have historically offered more-attractive returns relative to their volatility than their growth counterparts. This lends some credence to the view that investors may extrapolate past growth too far into the future, which can create systematic mispricing that might contribute to value stocks' return advantage. But even if these stocks are undervalued, they can remain out of favor for years, so they do not offer easy profits. The value effect could also become smaller as more investors attempt to take advantage of it.

Mid-cap stocks may be a little more likely to be mispriced than their larger counterparts because they generally don't attract quite as much analyst coverage. This may help explain why the performance gap between value and growth stocks has tended to increase as market capitalization decreases. But larger differences in required return could also contribute.

The fund's broad reach and market-cap-weighting approach limits its exposure to the cheapest stocks, which may also limit its return advantage. Market-cap-weighting skews the portfolio toward the larger stocks in the mid-cap market segment, which are not necessarily the cheapest. It also allows market prices to determine the portfolio’s sector weightings, which are unconstrained. However, this approach fosters low turnover and should reduce risk relative to a more exaggerated value tilt.

Like most of its peers, the fund has greater exposure to the financial services, energy, and utilities sectors than the broad CRSP U.S. Mid Cap Index, and less exposure to consumer cyclical, industrial, and technology stocks. This broadly diversified portfolio includes more than 200 holdings, and the top 10 account for less than 10% of the portfolio.

At of the end of October, the fund was trading at a considerably lower price/forward earnings multiple (16.9) than VOT (25.4). However, differences in expected growth rates appear to justify that gap. The fund is currently trading at a comparable price/fair value multiple (0.99) to its growth counterpart (1.00), based on Morningstar equity analysts' assessments of each fund's underlying holdings.

Portfolio Construction The fund employs full replication to track the market-cap-weighted CRSP U.S. Mid Cap Value Index. CRSP defines mid-cap stocks as those smaller than the largest 70% of the U.S. stock market by market cap and larger than the smallest 15%. It then assigns composite value and growth scores to each of these stocks based on several characteristics. The growth metrics include projected short- and long-term earnings per share growth, three-year historical earnings and sales per share growth, current investment/assets, and return on assets. CRSP evaluates value on book/price, forward and trailing earnings/price, dividend yield, and sales/price. It fully allocates stocks with the strongest value characteristics to the mid-cap value index until it represents half the assets in the mid-cap market.

CRSP keeps 100% of each stock in its respective style index until it passes through a buffer zone. At that point, CRSP only moves 50% of the stock from one style index to the other. If the stock stays on the opposite side of the buffer zone at the following quarterly review, CRSP will transfer the remaining half. This approach may help mitigate turnover where it does not significantly affect the fund's style characteristics. It should also reduce the market impact cost of rebalancing.

Fees Vanguard's razor-thin 0.09% expense ratio makes this the cheapest mid-value ETF available. The fund engages in securities lending, the practice of lending out the underlying holdings in exchange for a fee. This ancillary income partially offsets the fund's expenses. During the past year, it lagged its benchmark by 3 basis points.

Alternatives

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