By Alex Bryan
Unlike most value index funds, PowerShares Dynamic Large Cap Value (NYSEARCA:PWV) screens for stocks on investment merit in addition to traditional value characteristics. This approach more closely resembles an active strategy than a passive strategy, as do its fees (0.59% expense ratio). But despite its high expense ratio, this fund has outperformed most of its large-value peers since its inception in March 2005. PWV may be a suitable core holding for intrepid investors who wish to adopt a complex approach to value for a chance to outperform traditional value index funds.
While value stocks tend to outperform over the long run, they often represent companies with relatively high business risk and poor prospects for growth, and they may remain out-of-favor for years. PWV attempts to improve risk-adjusted returns by evaluating stocks that pass its initial value screens along the following five dimensions: price momentum, earnings momentum, quality (for example, return on equity, asset turnover, profit margins), management action (change in capital expenditures, share buybacks), and value.
While that approach has allowed the fund to generate higher returns with less volatility than most peers since its inception in 2005, it is difficult to predict whether this superior performance will continue. There is a danger that NYSE Euronext (which created the methodology for the fund's underlying index) overfitted historical data in selecting these additional investment merit metrics. In fact, in order to develop methodology for the Dynamic family of indexes, NYSE Euronext evaluated over 150 factors and found 47 that were statistically significant in identifying superior performing stocks. Yet some of these factors may not consistently work out of sample, a classic data-mining problem. This problem is less pronounced for the fund's momentum and value factors, as these investment styles have consistently outperformed in nearly every market studied over long time horizons. Academic research also suggests that quality metrics, including profitability, may improve risk-adjusted returns. But while many of the fund's factors may work well in isolation, it is less predictable how they will perform together. PWV's concentrated portfolio (which consists of only 50 holdings) can also lead to uneven performance. For instance, in 2009 and 2010 the fund lagged 65% and 90% of its large-value peers, respectively.
To its credit, PWV offers pure value exposure with few large-blend names in the mix. Over the past five years, the fund exhibited lower correlation (0.91) with its growth counterpart, PowerShares Dynamic Large Cap Growth Index (NYSEARCA:PWB), than did most value and growth index pairs. Consequently, it may offer better diversification benefits.
Since its inception in March 2005, PWV has established an impressive record. From March 2005 through June 2013, it generated an 8.8% annualized return with about the same level of volatility as the S&P 500 Index, which posted a 5.8% annualized return over that span. The corresponding figures for the United States open end and ETF large value category averages were 4.6% and 6.1%, respectively. During this time, PWV also exhibited less volatility than many broad U.S. large-value index funds, including iShares S&P 500 Value Index (NYSEARCA:IVE). The fund's quality and momentum selection criteria should help it continue to give investors a smoother ride than most of its large-value peers, even if it does not continue to outperform.
Because it incorporates quality metrics into its portfolio construction process, the fund's holdings tend to have better profit margins, higher returns on equity, and higher returns on invested capital than many of its value peers. These selection criteria also reduce the fund's exposure to distressed companies, which value funds often overweight. This quality tilt may partially explain why the fund held up better than its peers in 2008. While quality companies typically command higher valuations, the fund's portfolio usually carries a slightly lower average earnings multiple than most of its peers.
Combining value with momentum may also help reduce volatility by reducing exposure to value traps--stocks that look cheap but have deteriorating fundamentals. Momentum is based on the premise that securities that have recently gone up in value will continue to go up in the short run, and those that have lost value will continue to underperform. While there are a few competing theories explaining why momentum exists, one of the most compelling is that investors tend to under-react to new information. But whatever the cause, there is substantial evidence that momentum is a pervasive force. The fund leverages both price and earnings momentum, such as earnings surprises and positive analyst earnings estimate revisions, which may help it identify attractively valued stocks with improving fundamentals.
Despite the fund's value tilt, it currently looks fairly valued based on Morningstar equity analysts' assessments of the fund's underlying holdings. While rising interest rates could create a headwind, as the Fed unwinds its bond-buying program, we remain optimistic about the long-term fundamentals of the U.S. economy. According to Morningstar's director of economic analysis, Robert Johnson, consumer debt as a percentage of income has declined from 140% to 112% between 2008 and 2013. Bank balance sheets have also significantly improved over the past few years. Manufacturing productivity and oil production have picked up, and inflation remains low, while the unemployment rate has continued its gradual decline. These are signs of a strengthening U.S. economy, which should continue to benefit the fund's holdings.
The fund uses full replication to track the Dynamic Large Cap Value Intellidex Index. The index assigns composite value and growth scores to each of the 250 largest U.S. stocks by market cap, using five value metrics (forecasted earnings/price, which receives a 50% weighting; book/price, 12.5%; sales price, 12.5%; sales/price, 12.5%; cash flow/price, 12.5%; dividend yield, 12.5%), and five growth metrics (forecasted earnings growth, 50%; historic earnings growth, 12.5%; sales growth, 12.5%; cash flow growth, 12.5%; book value growth, 12.5%). It subtracts the value score from the growth score and classifies the 100 stocks with the lowest composite scores as value stocks.
The index ranks these 100 stocks by investment merit based on five dimensions: price momentum, earnings momentum, quality, management action, and value. It then selects 15 of the 20 largest stocks with the highest investment merit scores and assigns a 3.3% weighting to each name (for a total portfolio weighting of 50%). From the 80 smaller stocks on the initial list, the index assigns a 1.4% weighting to each of the 35 names with the highest merit scores. This approach ensures that the final portfolio will approximate the market-cap distribution of a broad-market equivalent without allowing a single stock to dominate the portfolio. The index is rebalanced quarterly.
PWV's 0.59% annual fee is not lower than many actively managed alternatives. It is hard to justify paying that much for a passively managed large-cap U.S. equity fund no matter how sophisticated its construction methodology is. Over the past three years, the fund lagged its benchmark by 0.81% annualized, implying non-expense ratio-related frictional costs of about 0.22% annualized. This isn't surprising given the fund's high turnover, which reached 58% over the past year.
Vanguard Mega Cap Value Index ETF (NYSEARCA:MGV) (0.12% expense ratio) is one of the best low-cost alternatives to PWV. The benchmark MGV tracks applies similar screens for value; however, it does not overlay an investment merit selection approach and has greater exposure to large-blend stocks. MGV makes up for this with its lower fee and lower turnover, which can make it a more tax-efficient alternative. MGV can lag PWV by nearly 0.5% and still provide the same returns net of fees. Over the past three years, these funds were 0.98 correlated.
Similar to PWV, Guggenheim S&P 500 Pure Value (NYSEARCA:RPV) (0.35% expense ratio) offers pure exposure to value stocks. It even weights its holdings based on the strength of their value characteristics. However, like PWV, RPV exposes investors to high turnover and transaction costs.
Because small-cap value stocks have historically exhibited a larger value premium than large-cap stocks, investors who can tolerate a little more risk might consider a small-value fund. Vanguard Small Cap Value (NYSEARCA:VBR) (0.10% expense ratio) is one of the cheapest and most liquid options in this category.
Many dividend strategy funds also offer a strong value tilt. Within this category, WisdomTree LargeCap Dividend (NYSEARCA:DLN) (0.28% expense ratio) and Vanguard High Dividend Yield Index ETF (NYSEARCA:VYM) (0.10% expense ratio) may be suitable vehicles. PowerShares FTSE RAFI US 1000 (NYSEARCA:PRF) (0.39% expense ratio) offers an alternative way to tilt toward value. It weights holdings on fundamental measures of economic size, such as sales and book value. This approach gives PRF a contrarian bent that enables it to capitalize on temporary market mispricings.
Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.