Value at Inflection Point?

Sunday, June 27, 2010

Recent years have bucked trends in the perennial growth vs. value competition. Value tanked during the Credit Crisis of 2008 when it should have outpaced growth, and now with a confirmed economic recovery value is gaining when it should be ceding ground to growth. There is contradictory evidence for whether can sustain its run.

Historically the argument for value has been that it is inherently less volatile and more defensive in a bear market. But over the past three years and especially during the worst of the stock market crash, iShares Russell 3000 Value ETF (NYSEArca:IWW) fell behind its growth counterpart, iShares Russell 3000 Growth ETF (NYSEArca:IWZ):

And now that a tepid recovery is confirmed value is jumping ahead:

Much of this behavior can be explained by heavy exposure to financials. Financials constitute over 20% of company holdings in a typical value ETF, compared to under 10% in a typical growth ETF. Financials took it on the chin badly during the Credit Crisis of 2008. As financials recover, the "banking effect" should mostly dissipate in 2010 or 2011. Value is not a direct way to play a rebound in banking directly, however. Sector ETFs are more suitable.

Long periods of dominance of one over the other are the norm for value/growth, and the longer one has been on top the more likely it will fall relative to the other. It is not unreasonable to ask whether value can sustain further advances. The answer is debatable.

What makes value attractive now is that it has trailed for some time, and it should absorb future economic shocks better than growth. This is clearly a period of shocks. Another item in its favor is the approximately 1% additional dividend yield its churns out. Investors are seeking income in the current low-yield environment.

What makes value less attractive now is the tepid recovery of the US economy (and indeed the world economy). Recovery traditionally favors growth. Also, valuations for growth are at historically moderate levels compared to value. IWW sports a PE of about 14 while IZZ only carries 16. It normally costs a bit more for growth relative to value.

Value enthusiasts once pointed to research by Fama and French as evidence that value performs better than growth AND at lower risk. In the 1990's when the data looks most convincing, value started a long period of underperformance. Fewer academics today claim a free lunch with value.

A typical value ETF will split up an index and take firms with a low projected price-to-earnings ratio (P/E), earnings growth, price-to-book ratio, and revenue growth, but a high high dividend yield.

Many fine plain vanilla ETFs serve value at low cost. They are differentiated primarily by the size of firms they address:

  • iShares Russell 1000 Value ETF (NYSEArca:IWD): 1000 largest firms, .20%/year fees
  • iShares Russell 2000 Value ETF (NYSEArca:IWN): 1001-2000 largest firms, .25%
  • iShares Russell Midcap Value ETF (NYSEArca:IWS): 201-1000 largest firms., .25%
  • iShares S&P 500 Value ETF (NYSEArca:IVE): 500 largest firms, .18%
  • iShares S&P MidCap 400 Value ETF (NYSEArca:IJJ): 501 to 900 largest, .25%
  • iShares S&P SmallCap 600 Value ETF (NYSEArca:IJS): 901 to 1500 largest, .25%
  • SPDR Dow Jones Wilshire Large Cap Value ETF (AMEX:ELV): largest 750, .20%
  • SPDR Dow Jones Wilshire Mid Cap Value ETF (AMEX:EMV): 501-1000 largest, .25%
  • SPDR Dow Jones Wilshire Small Cap Value ETF (AMEX:DSV): 751-2500 largest, .25%
  • Vanguard Value ETF (AMEX:VTV): 750 largest firms, .11%
  • Vanguard Mega Cap 300 Value ETF (NYSEArca:MGV): 300 largest firms, .13%
  • Vanguard Mid-Cap Value ETF (AMEX:VOE): 301-750 largest firms, .13%
  • Vanguard Small-Cap Value ETF (AMEX:VBR): 751-1750 largest, .12%

The above products have reasonable fees (with Vanguard as usual leading the pack) and are based on well-regarded, modern, capitalization-weighted indexes. SPDR uses Dow Jones Wilshire indexes, while iShares deploys both Russell and S&P indexes, and Vanguard depends on MSCI. It is useful that most ETFs in each line are complementary and have no overlap. By sticking to one product line, an investor can overweight one asset class with clarity and precision. Among the exceptions is iShares' IWW which is a nearly total market product, Vanguard's VTV which is the sum of MGV and VOE, SPDR's ELV which overlaps other Wilshire ETFs in mid-cap and likewise iShares' IWS.

There are also funds through Rydex and Morningstar which claim to more accurately capture value as a concept in their index methodologies. They tend to be a little more expensive:

  • Rydex S&P 500 Pure Value ETF (NYSEArca:RPV), 500 largest firms, .35%
  • Rydex S&P MidCap 400 Pure Value ETF (NYSEArca:RFV), 501-900 largest, .35%
  • Rydex S&P SmallCap 600 Pure Value ETF (NYSEArca:RZV), 901-1500 largest, .35%
  • iShares Morningstar Large Value Index Fund (NYSEArca:JKF), .3%
  • iShares Morningstar Mid Value Index Fund (NYSEArca:JKI), .3%
  • iShares Morningstar Small Value Index Fund (NYSEArca:JKL), .3%

There are also several ETFs based on proprietary enhanced or fundamental indexes. These funds sometimes deliver higher returns, sometimes lower.

Fundamental Value ETFs

  • First Trust Large Cap Value Opportunities AlphaDEX Fund (NYSEArca:FTA), .7%
  • Powershares Dynamic Large Cap Value Portfolio ETF (NYSEArca:PWV), .63%
  • Powershares Dynamic Mid Cap Value Portfolio ETF (NYSEArca:PWP), .63%
  • Powershares Dynamic Small Cap Value Portfolio ETF (NYSEArca:PWY), .63%

And finally there are short and leverage value ETFs suitable for speculative traders looking for a short-term play:

Short/Leverage Value ETFs

  • ProShares Ultra Russell 1000 Value ETF (NYSEArca:UVG), .95%
  • ProShares Ultra Russell 2000 Value ETF (NYSEArca:UVT), .95%
  • ProShares Ultra Russell MidCap Value ETF (NYSEArca:UVU), .95%
  • ProShares UltraShort Russell 1000 Value ETF (NYSEArca:SJF), .95%
  • ProShares UltraShort Russell 2000 Value ETF (NYSEArca:SJH), .95%
  • ProShares UltraShort Russell MidCap Value ETF (NYSEArca:SJL), .95%

Co-founder of indexfunds.com, author of two books on investing, and founder of ETFzone.com, Will has been writing on indexing issues for 8 years. He holds an MBA from the University of Texas at Austin.