As most investors have surely heard by now, value stocks are having a moment. After more than a decade of underperformance, value stocks have been beating growth handily for all of 2021. But “value” is a broad term, one defined differently by hundreds of active managers and exchange-traded funds. And as the value rally goes on, it will become increasingly important that investors choose carefully.
Like active managers who often disagree as to which companies have good value, ETFs and their underlying indexes are constructed in ways that can vary dramatically, which can lead to dramatically different returns.
Although the recent value comeback is fairly broad-based, some areas have bounced back more than others. Small-cap value ETFs led the way early in the year, and then fell sharply as international and large-cap value pulled ahead. There are more than 200 ETFs categorized as “value” by Morningstar, and since September, when the value rally began, their performance has ranged from 4% to 77%.
Such a back-and-forth signifies how changeable, even volatile, the value rally could be, as the global economy emerges from an unprecedented pandemic. That means looking under the hood is especially important now. To handle the market’s ups, downs, and intrasection rotations, value investors need a good mix of ETFs.
For diversified exposure to cheap stocks in the U.S., the $2 billion Invesco S&P 500 Pure Value ETF (ticker: RPV) and $356 million Invesco S&P SmallCap 600 Pure Value ETF (RZV) are likely to benefit more from value stocks’ further rising. The two funds are relatively concentrated, with just 122 and 180 holdings, respectively, unlike other value funds owning hundreds or even thousands of names. Another standout characteristic: Unlike most ETFs whose holdings are weighted by their market cap, the two Invesco value funds assign heavier weight to cheaper names, offering deeper value and more potential upside.
But don’t stop there. As some corners of the value rally are starting to slow down, or even retreat from their highs, three areas seem best positioned to harvest the next leg of gains—quality, momentum, and international small-cap value ETFs.
As the economic recovery decelerates, the best returns in value stocks will likely shift from the deep-discount, lower-quality names to higher-quality issues valued at a reasonable price. Just like active managers who check for quality to weed out shares that are value traps, many index-tracking ETFs are trying to do the same thing in broader strokes.
The $204 million American Century STOXX U.S. Quality Value ETF (VALQ), for example, screens and weights stocks based on fundamental measures of quality, value, and income. The $110 million iShares US Small Cap Value Factor ETF (SVAL), launched just a few months ago, adopts a similar approach to small-caps. The fund eliminates the Russell 2000 stocks that rank at the bottom among peers in terms of liquidity, volatility, leverage, and earnings sentiment, and then weights the remaining ones based on their valuation. And the $49 million Roundhill Acquirers Deep Value (DEEP) checks companies financial statements for potential fraud, earnings manipulation, and financial distress.
Another way to capture value gains is by monitoring price momentum. The $228 million Invesco S&P SmallCap Value with Momentum (XSVM), for example, selects the 240 stocks from the S&P SmallCap 600 index that have the cheapest valuations, and then invests in the 50% of them with the strongest recent upward price movements. It has returned 74% since September, beating the Invesco SmallCap S&P 600 Pure Value ETF by more than 12 percentage points. Over the past 10 years, the two funds had annual average returns of 13.5% and 9%, respectively.
The $26 million Invesco S&P 500 Value with Momentum ETF (SPVM), similarly, has also outperformed peers that don’t take momentum into consideration. The fund returned an average of 12.9% over the past five years, beating the Invesco S&P 500 Pure Value ETF by more than two percentage points each year.
Investors should also look beyond the U.S. borders. When it comes to investment returns and debt levels, international small-caps in other developed markets usually have higher quality, but often trade at a deep discount, on average, to their U.S. counterparts. That creates an attractive value proposition.
The $385 million Invesco FTSE RAFI Developed Markets ex-U.S. Small-Mid ETF (PDN), even though it’s not a value fund per se, offers exposure to international small-caps with a value tilt. Its underlying index, sponsored by pioneer smart-beta investment firm Research Affiliates, selects and weights stocks by fundamentals—such as book value, cash flow, sales, and dividends—instead of market value.
The ETF then systematically sells when stocks have rallied and buys when they’re out of favor, resulting in a natural tilt toward underpriced stocks in its portfolio. The fund has returned an annualized 6.3% over the past decade, beating most international value ETFs during the period. The largest one in the group, the $12.2 billion iShares MSCI EAFE Value ETF (EFV), gained an average of 3.5%, in comparison.
Write to Evie Liu at [email protected]
