Getting Some Value While Being Sector Savvy

As the smart or strategic beta class of exchange traded fund has gained momentum and, more importantly, assets, the funds occupying this fast-growing segment of the ETF universe have also become increasingly sophisticated.

In fact, some established factor-based ETFs have even changed indexes in an effort to deliver a better investment product. Such is the case with the iShares MSCI USA Value Factor ETF VLUE, which earlier this year transitioned to the MSCI USA Enhanced Value Index from the MSCI USA Value Weighted Index. The iShares MSCI USA Value Factor ETF, which is two and a half years old, has nearly $693 million in assets under management, making it one of the more well-heeled strategic beta ETFs focused on U.S. equities to come to market over the past two years. 

Home to large- and mid-cap stocks, VLUE's underlying index “is designed to represent the performance of securities that exhibit higher value characteristics relative to their peers within the corresponding GICS sector. The value investment style characteristics for index construction are defined using three variables: Price-to-Book Value, Price-to-Forward Earnings and Enterprise Value-to-Cash flow from Operations,” according to MSCI. 

VLUE's holdings “are weighted according to both their market-capitalization and the strength of their value characteristics, rescaled to maintain sector neutrality. This approach allows the fund to maintain a deeper value tilt than many of its market-cap-weighted value index peers, despite having greater exposure to traditional growth industries,” said Morningstar in a recent research note.

Although VLUE espouses sector neutrality, that does not mean this is an equal-weight ETF at the sector level. In fact, technology stocks are roughly 20 percent of the fund's weight, or 350 basis points more than the weight assigned to financial services stocks. Six of VLUE's top 10 holdings hail from one of those two sectors.

At the core of VLUE's methodology is capturing stocks that look attractively valued compared to their sectors. The apples-to-apples comparisons make sense and have the potential to work in VLUE's favor. After all, when measuring a technology stock's valuations, it makes more sense to do so against other tech names rather than against the health care sector.

“The fund's sector-neutral approach may help investors mitigate unintended bets, but there are some drawbacks. It allows the market to dictate the fund's sector weightings. So if a sector is richly valued, this fund will have greater exposure to it than its market-cap-weighted value index peers. Similarly, it doesn't take a stand on beaten-down sectors, allowing their weightings to decline with the market's appetite for them. Rebalancing back to sector-neutral weightings also requires greater turnover than allowing them to float, which can increase transaction costs,” according to Morningstar.

In terms of costs, VLUE is inexpensive compared to smart beta ETFs with an annual fee of just 0.15 percent. VLUE has gained 29.3 percent since coming to market in April 2013, slightly lagging the S&P 500 over that span.