Find the Value in ETF Value Investing

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Value investing has been out of style for a while now. Joining me to share some picks for investors who'd like to play a resurgence in value investing is Alex Bryan. He is Morningstar's director of passive strategies research in North America.

Alex, thank you so much for being here.

Alex Bryan: Thank you for having me.

Benz: You devoted the latest issue of Morningstar ETFInvestor to value investing. Let's just talk about the basic thesis behind value strategies or the value factor.

Bryan: So, basically, value stocks over the very long term have offered attractive performance, and I think there's two reasons for that. One, value stocks are, I think, more likely to be undervalued than their pricier growth counterparts. There's a tendency among a lot of investors to get really excited about fast-growing stocks, and I think some investors may extrapolate past growth too far into the future and overpay for growth stocks, while investors may become overly pessimistic about slow-growing companies or firms that are going through operational difficulties and push their price below their fair value. The fact that the payoff to value investing has historically been the biggest among the smaller stocks suggests that mispricing maybe at work.

But even if there's no mispricing, investors may require value stocks to offer expected returns as compensation for their higher perceived risk. Because a lot of value stocks, you know, they are less desirable businesses and investors may think that they are riskier. So, if you think about a firm like JC Penney, certainly not growing quite as fast as a firm like Netflix, and I think a lot of investors may only want to buy something like JC Penney if they thought it was going to offer a higher expected return. So, I think it's a combination of mispricing coupled with the fact that a lot of investors require compensation for owning these riskier stocks.

Benz: We've been in the midst of a period where growth stocks have dramatically outperformed value names. Can you talk in general about what factors, what forces tend to drive those types of cycles?

Bryan: Sector tilts certainly have been part of the reason why value stocks have underperformed. Traditional value indexes tend to be persistently overweight certain sectors like energy, financial services, underweight others like technology and healthcare. And over the past decade that certainly detracted from their performance. But at the end of the day, ultimately, what matters is growth relative to expectations, and I think a lot of growth stocks have exceeded investors' wildest expectations over the last decade or so. So, even though they were priced for growth, they've done even better than a lot of people expected, while in aggregate, a lot of value stocks have disappointed. So, it's hard to point to just one thing. But I think it's a combination of those sector tilts coupled with growth stocks beating expectations.

Benz: Investors might be looking at this underperformance of value stocks and think, aha, they are really cheap now, maybe I should get out of growth stocks entirely and move everything into value names. Is that sort of either/or mindset a good strategy?

Bryan: You know, it might be tempting to do that, but there isn't a lot of evidence that that actually works. I've done some research on this, and it just doesn't look like there's a good way of timing exposure to value or growth or knowing when it's going to outperform. So, I think it's important to have a long investment horizon if you are going to be a value investor.

Benz: For investors who are looking at their portfolios today and seeing that their portfolios are maybe heavy on the growth side of the style box and light on value stocks, let's talk about just a very cheap plain-vanilla way to play the value factor.

Bryan: I think Vanguard Value ETF is a really good place to start. This is a really simple broad market-cap-weighted value index fund that basically targets large-cap stocks representing the cheaper half of the U.S. large-cap market. It weights its holdings based on market capitalization. So, it effectively diversifies firm-specific risk. It accurately represents the way that a lot of active manages are investing, and it charges a very low 5 basis-points-expense ratio, which gives it a sizable cost advantage against its actively managed peers.

Benz: One risk, though, with a product like this is that you can get these sector biases that crop up. And you mentioned financials being sort of a persistently heavy overweight among many value-oriented funds. You have an ETF that you like that controls for big sector bets. This is iShares Edge MSCI USA Value Factor. The ticker is VLUE. Let's talk about that one.

Bryan: So, that's a mouthful. But what it does is it basically selects stocks that are the cheapest within each sector. So, it's looking for stocks that are cheap relative to their sector peers. And then it anchors its sector weightings to those of the broad market. Now, there's two principal advantages of this sector-relative approach. Number one, you are able to isolate exposure to the value factor without some of the ancillary sector bets that come along with that with a lot of traditional value index funds. And that's a good thing because persistent sector biases typically aren't well rewarded over the long term.

But the second benefit is that by comparing stocks in each sector that leads to better comparability. Because there's more similar balance sheets between firms within the same sector, there's more similar operational risk and profitability. So, I think it lends itself to better comparisons when you are looking at banks and comparing their valuations against other banks rather than taking a bank and comparing it against the tech firm. So, I think there's more informational content that you can glean, and I think that this type of approach will also help you really get clean exposure to the value factor.

Benz: In your research, Alex, one thing that you found was that the value factor was particularly pronounced in the small-cap space. So, for investors who are intrigued by that idea, who want to make sure that they have smaller-cap value exposure in their portfolios, is there any product that you would recommend there?

Bryan: I would keep it really simple and stick with a low-cost option like Vanguard Small-Cap Value ETF, ticker VBR. This is a fund that basically, again, offers very broad exposure to U.S. small-cap value stocks, targeting basically the cheaper half of the U.S. small-cap market. And then, it weights its holdings based on market capitalization. Now, this fund doesn't control for any sector tilts. So, there is a risk. But I think this is a really good option for exposure to small-cap value stocks, and it's one of the cheapest ways to invest in that part of the market.

Benz: Interesting research, Alex. Thank you so much for being here with us to discuss it.

Bryan: Thank you for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.