Value ETFs shine as turbulence returns to markets

For decades, owning value stocks has been viewed as the discipline of curmudgeons, chicken littles who claim that everything is too expensive and that regression to the mean is coming — sinking the overhyped and elevating the misunderstood.

Despite years of underperformance, value exchange-traded funds have been stalwart asset gatherers. Now, with the return of market turbulence, value stocks are winning the day.

For the 12 months ended Feb. 17, U.S.-focused value ETFs have steadily outpaced growth, returning about 15% or more, including reinvested dividends, according to FactSet Research Systems Inc. Growth products have experienced single digit to negative returns over the same period, but still sport five-year returns beyond the grasp of value strategies.

Those returns helped push growth ETFs to $352 billion in assets, according to FactSet, despite being significantly outpaced in net flows over the past few years. U.S. value ETFs currently hold $366 billion in assets, taking in $93 billion over the last three years, compared to growth ETF net flows of $15 billion.

"The shift from growth to value ETFs is a trend that many investors have been anticipating for years given the prior multiyear stretch of growth outperformance," said Ryan Barksdale, head of adviser portfolio analytics and consulting at Vanguard Group in Malvern, Pa.

Some of the shift to value is due to rebalancing trades or shorter-term valuation-based trades, Mr. Barksdale said. He added that Vanguard is also seeing some investment advisers expressing "a strategic belief that we're early in the value cycle based on longer-term expectations." In fact, recent research from Vanguard's investment strategy group expects "value stocks to outperform by as much as the historical equity risk premium over the next decade, primarily because of a decay in the overvaluation of growth stocks," Mr. Barksdale said.

But just because an ETF has "value" in the title doesn't mean it's full of the cheapest stocks. Like many other areas of ETF investing, subtle differences in index methodology and management style can have significant impact on risk and return. For example, the $101 billion Vanguard Value ETF, tracking the CRSP U.S. Large Cap index, has a weighted average price-to-earnings ratio of 15.2, according to Morningstar Inc., whereas the $3.8 billion Invesco S&P 500 Pure Value ETF has a much lower P/E at 10.8. (By comparison, Vanguard Growth has a 30.9 P/E, while Invesco Pure Growth comes in at 20.7.)

Products can not only swing widely in weighted average valuation, but also in sector and security exposure. In a recent research note, Todd Rosenbluth, head of mutual fund and ETF research for CFRA in New York, highlighted the sector differences between the S&P 500 value index and the Russell 1000 value index. Both represent large-cap stocks, but the broader Russell index has a greater weighting to financials, while the S&P index is more weighted to consumer stocks and tech.

The largest ETF providers — BlackRock Inc., Vanguard Group Inc., State Street Global Advisors and Invesco Ltd. — feature value and growth ETF pairs across the U.S. equity landscape at relatively low expense ratios, yet divining sentiment from flows can be challenging with specific fund pairs. For example, iShares Russell 1000 Growth and iShares Russell 1000 Value from BlackRock are often used as trading tools by more short-term traders, compared with Vanguard products that attract more buy-and-hold investors.

"What's notable is that these (iShares) growth and value products are often not mirror opposites, with one gaining at the expense of the other," said Elisabeth Kashner, vice president and director of global fund analytics for FactSet in San Francisco. "Often, investors are attracted to — or rejecting of — both growth and value."

Current market conditions will also give growing ETF managers with differentiated product sets the opportunity to stand out, specifically those focused on active management or international exposures.

For example, on Feb. 1, Havertown-Pa.-based Alpha Architect LLC reverted to an active approach for its products, including U.S. and international quantitative value ETFs. This switch was made in light of the SEC's 2019 ETF Rule that puts indexed and active ETFs with full, daily transparency on equal footing in the use of custom baskets to create and redeem ETF shares.

"The decision boils down to eliminating a lot of unnecessary costs tied to index management and compliance," said Wesley Gray, CEO of Alpha Architect. "We also gain some trading flexibility, which can help at the margin."

Alpha Architect's value ETFs hold an equal weighting of 50 stocks selected on enterprise value relative to earnings before interest and taxes. Both Dimensional Fund Advisors LP and Avantis Investors, a unit of American Century Investments, are also utilizing fully transparent active ETF to build value portfolios.

The prospects for rising inflation and rising interest rates are driving greater attention to value, said Tony DeSpirito, chief investment officer of U.S. fundamental equities and portfolio manager of the BlackRock Equity Dividend Fund. Looking at nearly 100 years of return data, Mr. DeSpirito said that value has outperformed growth in periods of moderate to high inflation.

"It is only when inflation is very low that value performance pales," he said. And, as interest rates rise, to cool inflation, Mr. DeSpirito said that he sees value stocks "as shorter-duration assets than growth stocks, which generally have a greater portion of their net present value tied to future cash flows."