Active value fund managers were some of those hit hardest by the pandemic’s impact on markets and for many, it proved to be a knockout blow.
Already suffering from a decade of underperformance, value funds were brutally punished in the subsequent market recovery, as high-growth tech companies pushed markets to record highs in the ensuing months, leading to a cull of many active manager stalwarts.
As a result, when value found favour among investors following the publication of Pfizer’s vaccine results last November, there was a dearth of active managers in the space ready to capture the significant regime change.
In fact, out of the 212-strong Investment Association’s (IA) North America sector, the top four were ETFs targeting cyclical stocks such as energy and financials that tend to benefit when the economy is recovering.
The Xtrackers MSCI USA Financials UCITS ETF (XUFN) and the iShares S&P 500 Financials Sector UCITS ETF (IUFS) returned 29.8% and 29.3%, respectively, to the end of August, according to data from FE. The iShares S&P 500 Energy Sector UCITS ETF (IESU) and the Xtrackers MSCI USA Energy UCITS ETF (XUEN) followed closely behind with returns of 28.1% and 27.2%, respectively.
Meanwhile, from a global perspective, the iShares Oil & Gas Exploration & Production UCITS ETF (SPOG) and the iShares Global Water UCITS ETF (IH20) came second and fourth, respectively, out of 450 funds in the IA Global sector.
Investors sentiment to value has waned over the past few months, a note from JP Morgan last week said it has maintained its overweight to value tilted equities and that cyclicals likely “bottomed early last month”. So, if there proves to be a second coming for cyclical stocks, how can investors utilise ETFs?
Can you still be active on value?
For the active managers that survived the market depths of 2020, there are still some that have posted strong returns over the past 12 months. Leading the charge on the active side are value behemoths Ian Lance and Nick Purves who’s RWC UK Value fund has returned 40.2% over the past year, fishing in a heavily cyclical market, compared to the 30.9% of the IA UK All Companies sector.
Richard Philbin, CIO at Wellian Investment Solutions, said that while active managers may struggle to capture the growth to value rotation – or vise versa – this is because they generally tend to be more wedded to a particular style, as opposed to momentum ETFs that are not committed to a particular approach.
“You do tend to find active managers are pragmatic to a certain level but due to their investment style and approach, they tend to fall either side of the fence,” he said.
“You could say that value and growth is black and white and trying to capture the rotation is grey. Also, the styles tend to be longer-lasting where the transition between them is just that, a transition, and therefore shorter-lasting in nature.”
Dan Kemp, CIO at Morningstar, added he still utilises some very accomplished active value manages within his portfolio but is steadfast on the benefit of using ETFs to capture the rotation.
“For example, if you were using an index as the basis for your valuation analysis on the US markets, and then you go and buy an active manager of course you may get something very different,” he said.
“That is the benefit of ETF, there's a clear link between the valuation work that led you to think that market is undervalued and the implementation.”
How to capture the rotation with an ETF
One such way an investor can capture the growth to value rotation through the wrapper is by using momentum or smart beta products, instead of a pure index play, due to their ability to change their portfolio.
Philbin said: “The easy suggestion would be to find and then invest in the momentum funds as they are not wedded to an individual style or approach to portfolio construction.
“Smart beta products rather than pure index plays could also work as they would have their quant rules in place to change the portfolio accordingly between the two styles.”
This strategy however does come with a word of caution from Philbin. “One thing also to look for would be how often the portfolio is rebalanced too as this could add a lag to the process.”
As an example, the iShares Edge MSCI USA Momentum Factor UCITS ETF (IUMF) underwent a long-overdue swing into value in June, some six months after markets began their rotation away from growth stocks.
Another product that allows investors to value-tilt their portfolios in growth-heavy markets such as the US are equally-weighted ETFs.
Flows have tended to track investor sentiment on the value and growth over the past year, with the $4bn Xtrackers S&P 500 Equal Weight UCITS ETF (XDEW) has recording net inflows of $2.3bn over the past 12 months, despite an asset exodus of $2.5bn over the past three months as investors begin to question the reopening trade.
Despite this, Kemp said he would avoid such value tilts in favour of a research-led approach that allows him to look at individual industries, sectors and countries and not purely focusing on companies with low ratios to find value.
“If you do not have an entire universe of stocks then you are most likely candidates for undervalued businesses live in the areas of the market where they have low ratios. You find them more frequently there but that is not the only place you find them,” he said.
“The key is to have a broad enough approach you can find them wherever assets are underappreciated rather than simply allowing the ratios to determine where you invest,” he said.
A note from Research Affiliates published last week said renewed economic growth in emerging markets could be the catalyst for another cyclical shift into value. The JP Morgan note also said it remained overweight cyclicals in emerging markets – a play that Kemp is also positioning himself towards with ETFs.
He said: “More recently, we have invested in Mexican securities and are just starting to invest in Chinese technology as a part of the emerging market.
“It is not a classic value play that has quickly become disliked by the bull market for the reasons that we know and may well be already in the price.”
