ETF tips for investors hunting for value

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 rise in price.

Bargain stocks can be unearthed using common accounting ratios such as the price-to-book or price-to-forward-earnings ratios.

These allow a valuation to be anchored to the strength of an underlying business and to be comparable across different stocks. Value investing profits from the market’s tendency to overreact to both positive and negative news.

Like many investment strategies, value investing is highly cyclical and can underperform for long periods.

A value strategy tends to outperform in strong inflationary macro-environments, which means it can be expected to perform best in times of economic growth. This pro-cyclicality means value investors should expect a bumpy ride. But having said that, historically, there have been rewards for investors who have been able to hang on.

Perfect wrapper for value

The rules-based nature of value investing makes value easy to capture efficiently in an ETF wrapper. ETFs can do the heavy lifting of researching and selecting the right stocks, and they can offer high levels of transparency, which facilitates a full understanding of an ETF’s strategy and enables holdings to be reviewed on a daily basis.

What’s more, the most popular value ETFs charge a fraction of the fees charged by active fund managers following similar strategies.

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

Take your pick

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

Two options worth considering are the UBS MSCI USA Value ETF (UC07) and the iShares Edge MSCI USA Value ETF (IUVF). Both represent an efficient and diversified way to access cheaper stocks.

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

Understand the risks

When choosing the right value ETF, understanding the risks that come with individual ETFs is vital.

With its 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 that this is a riskier strategy. Historically, volatility for the iShares ETF has been higher than that for the UBS ETF.

A recent Morningstar study indicates that investors wanting to pursue a value strategy but who don’t have the stomach to ride out volatility can mitigate risk by adding quality to their portfolios. 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 stockmarket. As with the iShares Edge MSCI USA Value ETF, it assesses the stocks only against peers in their sectors, so the resulting basket is free from sector biases.

Alternatively, investors could 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 constrains exposure to less-profitable companies, which has helped limit its historical risk.

Dimitar Boyadzhiev  is a passive strategies research analyst for Morningstar

This article was originally published in our sister magazine Money Observer. Click here to subscribe.

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