Investment Road Test: Australian Value ETF

PORTFOLIO POINT: The high turnover of this ETF could leave investors wondering whether it is really a managed fund in disguise.

Exchange traded funds, or ETFs, have emerged as one of the fastest-growing investment products across the world, and as they grow in popularity so too have the variations of ETFs on offer. Investors keen to learn more about ETFs should visit the ASX resources by clicking here.

Where the original ETF issues sought to replicate index returns at lower costs than those offered by existing fund managers, recent innovations have seen active management techniques creep into a field that was once almost exclusively passive.

This use of ETFs has reflected investor dissatisfaction with actively managed funds, many of which fail to deliver the performance of the basic share indices they aim to beat, and it is through this prism we turn our attention to Russell Investments’ Australian Value ETF (RVL), which is closer in style to traditional actively managed funds, with a focus on value investing.

RVL uses a quantitative approach to select up to 60 stocks, which are filtered to create an investment skewed towards the “value” style. Value investing is sometimes described as the selection of stocks trading two-thirds below their net tangible asset (NTA) backing, but in modern times this is interpreted as any style of investment that looks for “cheap” stocks based on a range of measures.

Value investing, by definition, seeks to identify individual stocks whose market price is an inaccurate guide to real value, and is therefore essentially a method of beating the general market returns.

Value investing is often employed in small, concentrated portfolios, where the investor holds the position for the longer term – either until the company is liquidated or sold at a profit, or where the company engages new management to turn around its fortunes (for more on value investing, read Roger Montgomery’s weekly column Value.able here).

RVL uses an approach that is far closer in style to the traditional actively managed fund, and by doing so raises questions about its merit.

RVL uses a fairly simple value approach to selecting stocks – it looks at price/earnings (P/E) multiples and forward earnings growth (based on analysts’ forecasts) to select and rebalance its portfolio. The output from this model is used to determine the “Russell Value Index” – and then the RVL ETF tracks that index.

Material supplied by Russell indicates that the normal turnover of the shares within the RVL ETF may be as high as 50% pa, and that the index rebalancing happens twice yearly, at the end of February and August (to coincide with company earnings reports).

Whether the methodology used in the RVL index is “benchmark aware” is not disclosed by Russell, but it looks as though the approach used does seek to beat, but not underperform the broader ASX market. This “benchmark awareness” is the key performance drag for traditional actively managed funds. Excessive turnover produced by managed funds is also a key reason why traditional ETFs can be delivered for low fees and with often better performance than traditional funds.

Understanding the problem with benchmark aware funds is crucial when comparing them with ETFs. A much-used, but simplistic and superficial analysis of ETFs compared to managed funds sees ETFs as a “transparent” and “low-cost” alternative to the “black box” managed funds.

This is the central theme used by large US ETF research houses such as Alta Vista to explain the apparent usefulness of ETFs. But this argument is limited in its usefulness because it tries to link managed fund underperformance to the lack of “transparency” and “control” which prevails for large actively managed funds.

In fact the real problem with traditional managed funds stems from their high level of turnover – up to 80% pa – which arises from their mandate to beat but not underperform the broader market. It is likely that this is problem applies equally to any ETF that uses active techniques of stock selection.

For this reason investors should ask themselves whether their whizzbang new ETF is actually a managed fund in disguise.

Looking at the performance of the RVL ETF since its inception, it can be seen that its performance closely tracks that of the S&P/ASX 200 index, but is currently underperforming that index (although it has to be acknowledged that RVL has beaten the S&P/ASX 200 index for some periods).

The methodology of RVL ranks stocks based on their market capitalisation as well as relative value, so a higher weighting will be given to larger stocks than smaller stocks, whether or not the smaller-cap stocks are trading at better value.

High turnover is a problem because it exposes the portfolio to the highest possible levels of volatility. Research data shows that the highest levels of volatility occur for stocks that are turned over in less than 12 months, compared to longer periods: five years is normally seen as the timeframe after which the incidence of negative returns in a portfolio decline measurably.

Perhaps to overcome some of the problems of high turnover, the RVL holds a very large number of shares in the portfolio – far higher in number than is often recommended for investors seeking to beat an index. Studies such as those by Haggstrom & Archer show that 15 stocks is the ideal number to hold in order to beat the index.

The RVL ETF is an unusual hybrid in that it uses a low-touch, quantitative approach to stock selection – apparently satisfying the concept of “transparency” that some ETF proponents see as the main benefit of ETFs. The Russell website and marketing for RVL highlight this as a selling point, displaying the component stocks held within RVL on its website.

But the RVL approach to rebalancing a very large portfolio, driven by the dictates of the quantitative screens and filters, recreates the high-turnover, benchmark aware approach that bedevils traditional managed funds. Its fee of 0.34% pa is in line with normal ETFs and is certainly far lower than traditional managed funds. But in neither being a simple index replicator, nor a low-turnover concentrated portfolio provider, RVL seems to be an investment without a clear and logical rationale.

The score: 2.5 stars
0.5 Ease of understanding/transparency
1.0 Fees
0.5 Performance/durability/volatility/relevance of underlying asset
0.5 Regulatory profile/risks
0.0 Innovation

Tony Rumble is the founder of the ASX-listed products course LPAC Online. He provides asset consulting and financial product services with Alpha Invest but does not receive any benefit in relation to the product reviewed.