Fidelity Value Factor ETF: Vulnerabilities To Consider (NYSEARCA:FVAL)

Fidelity Value Factor ETF (FVAL) is yet another value-tilting exchange-traded fund favoring large-cap stocks I would like to dissect today. Since its inception in September 2016, FVAL has amassed ~$483 million in AUM, with encouraging asset flows trends.

Among the advantages that I would like to mention immediately is a small cash flow ingredient added to its investment strategy, as well as the quality of the portfolio (i.e., the profitability of companies it is most exposed to) which is close to perfect, and relatively robust performance since inception compared to the selected value-themed peers.

However, a few vulnerabilities, which I will be discussing in greater depth below, outweigh these advantages grossly.

In this regard, investors seeking maximalist value strategies that shun companies exhibiting growth characteristics or equally exposed to both value and growth styles, or who do not want to be overweight in tech stocks and underweight in financials/other cyclicals in the higher interest rates environment, should give this fund a pass and look for opportunities in the large-cap pure-value space or even take a close look at the lower echelons of the market which are by definition offer valuation discounts, sometimes quite generous. That said, I do not think it is worth investing in FVAL at these levels.

Investment strategy

According to the prospectus, FVAL tracks the Fidelity US Value Factor Index, which is rebalanced biannually.

Its selection pool consists of 1,000 U.S. companies with the highest free-float market capitalization.

Precisely like DSTL that I covered two weeks ago, the index adds an FCF ingredient to a value strategy, which in the case of most mainstream benchmarks does not look beyond Price/Earnings or a bit antiquated Price/Book, thus resulting in somewhat imperfect equity allocations and, consequently, skewed returns. However, this Fidelity index is not that much concerned with a company’s cash flow generation capabilities, since the FCF yield (FCF per share/share price) has just 25% weight in the composite factor score. Other metrics that have the exact same influence on the CFS are EBITDA/Enterprise Value, Tangible Book Value/Price, and Earnings over the next twelve months/Price. For banks, the list was trimmed, with only TBV/P and 12-month forward E/P weighted equally to arrive at the CF score.

I believe the key strength of the methodology is that

Composite scores are calculated separately within each industry group and then combined for each sector.

As a reminder, most value indices simply ignore natural differences in valuation between sectors.

However, because of the sophisticated, iterative portfolio construction process described on pages 4 and 16 of the methodology, including the sector neutrality principle, the index and FVAL portfolio are overweight in IT and underweight in traditionally cheaper sectors, which makes it more exposed to the broad growth premia reduction.

Returns overview: FVAL lags the market, FCF-mindful strategy

To assess if FVAL has succeeded in its effort to outmaneuver the market by tilting its portfolio towards the value factor, I would like to compare two peer ETF groups, with and without the Distillate Fundamental Stability & Value ETF (DSTL) which has a much shorter trading history encompassing less than four years for now.

As I discussed in the recent article, DSTL’s sophisticated methodology has proved it has an edge over the S&P 500, with higher returns since inception as well as relatively lower risks. Did FVAL achieve at least similar results? Well, it did better than value-focused peers, though without alpha and higher risk to boot.

In the first group, without DSTL but with Invesco S&P 500 Pure Value ETF (RPV), iShares MSCI USA Value Factor ETF (VLUE), and the iShares Core S&P 500 ETF (IVV), with the data for the October 2016 – January 2022 period, FVAL does not earn the highest score possible, as its attempt to outperform the market proved to be a flop, though it clearly stands out compared to other value names I selected, RPV and VLUE.

Its level of risk might look relatively lower if measured using the Sharpe and Sortino ratios, though the standard deviation points to the contrary.

What allowed FVAL to trounce RPV and VLUE? The most plausible explanation I can offer here is that it was the growth and not the value factor that allowed it to deliver more or less robust returns over that period when funds picking underpriced companies more aggressively, like RPV, were suffering amid the value-style drought of the late 2010s.

To corroborate, FVAL has ~26.4% of the net assets allocated to the stocks present in the Invesco S&P 500 Pure Growth ETF (RPG), including Amazon (AMZN), Microsoft (MSFT), and Oracle (ORCL), which are markedly overappreciated. RPV does not have that flaw.

Now, the second cohort, with DSTL included; the period is shorter, 31 October 2018 – 31 January 2022. Again, nothing spectacular. DSTL is number one with the highest CAGR, FVAL holds third position.

And finally, how has the fund fared amid the recent market sell-off? Much better than the 500 blue-chips, though not even close to RPV.

Portfolio

As of February 7, FVAL oversaw a portfolio encompassing 127 common stocks and REITs, while the top ten accounted for almost 31%. Its holdings have just ~47.7% weight in the S&P 500 ETF.

Oddly enough, we see all the four members of the $1 trillion league in the top ten group, with the weights barely different from those they have in the IVV portfolio. For example, Apple (AAPL) has ~7% weight in both.

FVAL’s sector allocation is similar to IVV, which is not coincidental given the weights are being reset at each reconstitution to ensure sector neutrality. So, while most funds focusing on low-multiple, underappreciated companies are overweight in financials (the low P/E, low P/B sector) or other cyclicals like industrials, FVAL is IT- and healthcare-heavy.

As usual, I have used the Quant data to assess if FVAL’s portfolio is overvalued, rich with growth stocks, or has a large exposure to the quality factor.

Regarding valuation, just ~33.5% have grades of B- or better. This is not ideal, of course, especially considering over 41% allocation to overpriced stocks (D+ or worse). 28.9% have growth characteristics, while around 91% boast sector-leading profitability.

Final thoughts

Investors seeking safety in value amid tech softness should ask themselves a few essential questions:

• Is there any rationale behind holding a value-themed ETF that has minor deviations from the S&P 500 in terms of sector exposure?
• Is the heavy top with all the same mega-tech bellwethers occupying key spots acceptable?
• Do growth players distort returns of otherwise perfectly calibrated value-style portfolios?

If the answer is “no, no rationale,” or “it is worth steering clear of mega tech,” “growth stocks should be scrupulously identified and separated,” then FVAL is a suboptimal fund to consider right now, especially given over 41% of its holdings have Valuation grades of D+ or worse.

I believe its relative outperformance in the past was mostly the by-product of its exposure to the growth factor; consequently, with this factor wilting in the hawkish scenario, that can become a drag on returns.

FVAL has an A- Dividend grade, with dividend growth rates and the yield being well above the asset class medians. In my understanding, value investors frequently seek not simply lower multiples, but higher yields also. But unfortunately, with ~1.4% distribution yield (marginally above IVV’s), the fund does not have that.

In sum, the ETF is a Hold.