Using ETFs to Find Good Value Investments

Value investing profits from the market’s tendency to overreact to both positive and negative news

Dimitar Boyadzhiev 6 April, 2018 | 7:36AM

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With surging equity markets pushing stock valuations above historical levels, investors have increasingly been turning to value strategies. Value investing is one of the most popular and intuitive active investment strategies. Famously championed by Warren Buffett, it involves identifying and buying cheap or unloved stocks in the hope that the market has mispriced them and that they will rebound in price.

Bargain stocks can be unearthed using common accounting ratios such as price-to-book or price-to- forward earnings. They allow a valuation to be anchored to the strength of the underlying business and comparable across different stocks. Value investing profits from the market’s tendency to overreact to both positive and negative news.

Like many factors, such as low size and momentum, value is highly cyclical and can underperform for long periods. Value tends to outperform in strong inflationary macro environments – meaning it is expected to perform best in times of economic growth. This pro-cyclicality means that value strategy investors should expect a bumpy ride. But having said this, historically there have been rewards for those who have been able to hang on.

Why ETFs?

The rules-based nature of value investing makes it easy to capture efficiently in an ETF wrapper. Not only can ETFs cover the heavy lifting of researching and selecting the right stocks, but they also benefit from high levels of transparency, which allows a full understanding of the strategy and holdings to be viewed on a daily basis. The most popular value ETFs also charge a fraction of the fee charged by active fund managers following similar strategies.

Unlike holding a handful of individual stocks, holding an ETF protects the investor from being overly exposed to a single stock or sector. ETFs offer diversified exposure, thus minimising idiosyncratic risk.

Picking the Right Value ETF

To demonstrate the differences between value ETFs, we will examine the US Value ETFs listed on the London Stock Exchange. US equities represent an important holding in many investors’ portfolios.

Two options worth considering are the UBS MSCI USA Value ETF and iShares Edge MSCI USA Value ETF. They both represent an efficient and diversified way to access cheaper stocks.

The UBS ETF’s benchmark tilts towards the cheapest stocks in the universe, regardless of sector, which may therefore introduce strong sector tilts. Currently, the index’s largest sector bias relative to the market is towards financial services at the expense of technology stocks. The MSCI USA Value index is made up of approximately 340 constituents, which represents half of those in the cap-weighted MSCI USA benchmark.

The iShares Edge MSCI USA Value ETF takes a different approach. The underlying index targets the cheapest stocks within each sector, which results in a sector composition close to that of the market. The fund holds 150 stocks.

When choosing the right value ETF, understanding the risks is key. With a more targeted approach to stock selection, the iShares ETF offers greater exposure to US equities that are inherently cheaper relative to their peers, but it is important to note this is a riskier strategy. Historical volatility for the iShares Edge MSCI USA Value ETF has been higher than that of the UBS MSCI USA Value ETF.

A recent Morningstar study indicates that investors wanting to pursue a value strategy, without the stomach to ride out the volatility, can mitigate risk by adding quality characteristics to their portfolio.

This could be achieved by combining the iShares Edge MSCI USA Value ETF with the iShares Edge MSCI USA Quality ETF. The latter applies screens to target quality stocks from the US stock market; similarly to the iShares Edge MSCI USA Value ETF, it assesses the stocks only against peers in their sector so the resulting basket is free from sector biases.

Alternatively, investors can choose to invest in the UBS Factor MSCI USA Prime Value ETF. It comprises the cheapest US stocks that are financially stable and profitable. While providing exposure to value stocks, this approach also limits the exposure to less-profitable companies, which has helped to limit its historical risk.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Securities Mentioned in Article
Security NamePriceChange (%)Morningstar
Rating
iShares Edge MSCI USA Val Fac ETF $ Acc6.75 USD-0.26-
UBS ETF MSCI USA Value USD A dis GBP5,743.50 GBX-1.02
About Author

Dimitar Boyadzhiev  is a Passive Strategies Research Analyst for Morningstar