How value ETFs choose stocks – and where they can surprise you

Investors have been flooding into value-focused exchange-traded funds (ETFs) faster than they have very trendy areas of the market like quantum computing, Robotics and AI of late.

‘Value’ refers to a style of investing where you target stocks you think are being valued too cheaply by the market and buy them, hoping to make a return once the market catches up to what you see as being the fair price.

These types of stocks often pay a dividend as well, classic examples being the UK’s Shell and BP.

It's the juxtaposition to ‘growth’ investing, which focuses on stocks expected to outperform the broader market because of their future growth prospects, and often lack a dividend as they reinvest profits in pursuit of that growth.

The tech sector for example, including the likes of Nvidia and Meta, is filled with companies that are typically classified as ‘growth’.

Determining if a stock does or doesn’t have value feels like a very human, subjective, decision, but more investors are accessing this style of investing through passive products including ETFs.

Passive investing offers an efficient way to capture everything deemed 'cheap' by the market, since an ETF will own a bit of everything in the index its following. But this strips out a lot of nuances about why some companies might be trading on lowly valuations and begs the question of whether passives are the right vehicle for this style of investing?

“There isn't necessarily a right or wrong answer for this,” says Paul Angell, AJ Bell's Head of Investment Research.

“Instead, it depends on what the investor is looking for in a value fund. In a passive fund, investors are buying into the methodology of the fund’s underlying index and therefore the companies selected, and even this can differ between funds."

How is ‘value’ measured then?

Common metrics used in the creation of value indices include a stock’s:

• price-to-book (P/B) – a company’s valuation versus its assets minus any liabilities,
• price-to-earnings (PE) a company’s valuation versus its earnings (either forecast or historic)
• ‘enterprise value relative to operating cash flow’, which translates to how much investors are paying for a company relative to the cash its underlying business generates.

But different indices will determine value on different metrics, using other figures like whether a stock is expensive versus its own history, for example.

This is why passive value funds can end up looking different to each other depending on the methodology of the underlying index, Angell notes.

Not what you might expect when you think of ‘value’

One thing that has changed about some of the most mainstream value indices in recent years, is that they look quite different from investors’ traditional perception of value, with the indices now having significant exposure to technology companies.

Taking the most popular value ETF among AJ Bell DIY investors, the iShares Edge MSCI World Value Factor UCITS ETF, it follows the MSCI World Enhanced Value index, and its biggest position is currently in chip maker Micron, a stock Ian Lance, Redwheel Global Intrinsic Value fund manager, said no active value manager “in their right mind” would regard as a value stock today.

Micron’s shares have risen by more than 700% in the past year.

But this is where discerning the definition of ‘value’ comes into play.

Whereas managers like Lance dispute Micron being a value stock, Bank of America argues that while the chip maker is expensive versus its own history, it’s extremely cheap based on its own future earnings forecasts, as demand for memory chips is expected to increase as AI usage climbs.

A similar argument could be made for funds tracking the MSCI ACWI Value index, which has a significant weighting to Microsoft, Meta and Micron again.

Value isn’t black and white

Simon Gergel, manager of Merchants Trust, said it isn’t necessarily a bad idea to use a passive value fund and could even be sensible long-term, but says the problem is that “it's very black and white by definition” because tracker funds just hold everything in the underlying index.

“You're going to miss a lot of nuance. There are companies that are lowly priced but deserve to be lowly priced, we might call them value traps and there's companies that are highly priced that actually deserve that because they might be good quality, high growth, businesses,” he says.

Avoiding value traps is what buying active value funds hopes to avoid, AJ Bell’s Angell explains.

“In terms of whether active or passive funds are better at exploiting the value factor, our analysis shows that many active value managers have done a good job of outperforming their passive equivalent on a 10-year view,” he says.

"An investor may favour an actively managed fund which may have an advantage through incorporating human judgement and qualitative insights to answer, ‘why is it cheap’, and ‘is the market wrong?’”.

Some value funds on the AJ Bell’s Favourite funds list are Dodge & Cox Worldwide Global Stock, Schroder Global Equity Income and Fidelity Special Situations.

The AJ Bell Investment Team include all three for their respective discipline to stick to their value investment principles, avoiding what is commonly known as ‘style drift’.

In the past few years, when the growth style of investing has outperformed value thanks to the ever higher rally in tech stocks, there’s been instances of value portfolios moving outside of their traditional focus.

Arguably, value indices having large allocations to stocks you wouldn’t historically have in this type of fund are representative of such a shift, albeit for different reasons.

In any investment decision, the important part is doing the research, understanding what is actually driving the portfolio and making sure that exposure is consistent with what you are hoping to achieve.