iShares FOVL ETF: Not The Best Fund To Play The Value Game

Today, I would like to discuss the iShares Focused Value Factor ETF (NYSEARCA:FOVL), a concentrated financials-heavy portfolio of the cheapest stocks in the Russell 1000.

Though asset flows are robust, FOVL has just ~$36 million in net assets. The expense ratio is 25 bps, slightly below the asset class median. The ETF also yields a decent 2.7%.

FOVL has a few strong advantages, namely large exposure to stocks with attractive Quant Valuation grades coupled with fairly solid quality. But I am hesitant to assign it a Buy rating due to drawbacks that are not to be ignored. The pros and cons deserve a thorough discussion that is presented below in the article.

Investment strategy

FOVL is a comparatively novel investment vehicle incepted on 19 March 2019.

The fund has what I would call a maximalist concentrated value strategy.

According to the prospectus, the fund tracks the equally-weighted Focused Value Select Index provided by FTSE Russell, which is supposed to encompass the U.S. upper- and mid-echelon equities with “prominent value factor characteristics.”

The Russell 1000 index (tracked by IWB) is its selection universe. To whittle the list down to the most underappreciated equities, the index provider first assesses the LTM realized volatility of the parent index constituents, removing those in the top 10%. I would not say that I appreciate this rule since less volatile stocks tend to underperform during the broad market recoveries after the steep declines.

In step two, the total debt/total assets ratio is used to identify the overleveraged companies; again, the top 10% cannot proceed to step three. I believe this rule was certainly added to minimize the risk of value traps percolating into the index, which would pose substantial threats to its returns; in many cases, excessive leverage combined with cheap valuation (which typically goes hand in hand with anemic growth) points to consistent shareholder value destruction by a company, thus such equities are better to be avoided.

In step three, analyst consensus earnings estimates are taken into consideration to spot stocks with a poor sentiment score; they are subsequently removed from the pool.

In step four, the weighted composite score amalgamating Price/Book, Price/Dividend, Price/Earnings, and Price/Net CFFO is used to select the top 40 equities “to form a baseline or target composition” of the index. The precise weights of these value factor metrics are discussed on page 11 of the methodology. Constituents are weighted equally, which staves off the risk of the benchmark (and the fund’s portfolio) becoming over-reliant on just a few names with the largest market capitalizations; the review happens every month, with rebalancing triggered in case certain conditions discussed on page S-2 of the prospectus are met.

The portfolio

As of March 18, FOVL had a portfolio of 40 stocks, with the top ten accounting for ~29.5%. My calculations show that the median market capitalization stood at ~$10.7 billion, with the weighted average figure at $21 billion. Overall, it seems FOVL should appeal to value investors who are skeptical about mega-caps.

Besides, the fund has a minuscule overlap with IWB (its holdings have ~1.9% weight in the latter), so it should be a nice option for value-focused contrarians trying to trim exposure to the broad market, focusing on underfollowed and misunderstood equities.

I have also checked if FOVL has similarities with the Invesco S&P 500 Pure Value Index (RPV), a solid bellwether value fund I discussed in January. The analysis revealed that equities present in both have ~36% weight in FOVL and ~17.7% in RPV.

Sector exposure of the focused value ETF surprised me a bit. I expected to see a fairly heavy presence of financials but not ~73% of the portfolio; its peer RPV is also heavy in banks and the like but with just ~31.7% allocation.

Oddly enough for a value fund, FOVL has no exposure to materials, industrials, and energy, the sectors that tend to trade at a discount to the broad market, with capital intensity being the likely factor influencing lower multiples. That is the key reason why I believe the ETF is a Hold despite its strong value characteristics discussed below: its sector exposure is out of proportion, even though most of its equities from the financial sector have either Hold or Buy Quant ratings.

Speaking of exposure to the value factor as measured by the Quant Valuation grade, the fund does hold a large share of grossly underappreciated equities, with those sporting an at least B- rating having almost 59% weight; that is not ideal but clearly acceptable.

Still, we see a surprisingly large allocation to growth stocks, or around ~27% of those with a B- grade or better; I reckon that figure would be much lower if the index used only value factor in weighting.

To bring a bit more color, the table below summarizes the Quant data for the top 25 holdings (~68.5% weight).

There is also an essential question worth asking. Does FVOL’s cheap valuation correlate with a lower level of quality? Thankfully, it does not, and it seems the screening for excessive leverage and negative sentiment also allowed to spot and remove those firms that have weak margins and poor returns on capital. Inspecting the FOVL portfolio, I found ~80% of the holdings have no less than a B- Profitability grade. That is a solid result but in fairness, that was also partly the consequence of its large-cap focus. In a mid-/small-cap portfolio, that figure would be much lower.

To bring even more color, below is the scatter plot illustrating NI margins and Return on Equity of FOVL’s holdings. I opted for these metrics since the EBITDA margin and ROTC that I use frequently make no sense for the financial sector.

We see just two loss-making companies, namely Vistra (VST) and Xerox (XRX), with the rest having decent margins and ROE; this once again reinforces the point that the quality of the portfolio is high.

Does a concentrated maximalist value portfolio beat the market?

For now, the answer is no. Not yet. We have just three full trading years to analyze, with most of the period during the coronavirus stock market era of excessive government stimuli. So I would say the results are mostly skewed by the ultra-loose monetary policy, and during the hawkish period, the fund might demonstrate a rather different performance, especially considering its heavy position in financials.

The table below compiles the returns of FOVL and a few selected peers, namely Invesco S&P 500 Enhanced Value ETF (SPVU), iShares Russell 1000 Value ETF (IWD), and RPV. IWB is supposed to represent the broad market. The period in focus is April 2019 – February 2022.

As seen, FOVL’s CAGR is the weakest, only ~10.2%. The Sharpe and Sortino ratios are also poor, pointing to a lower reward for higher risk.

The silver lining I see here is its best year (2021) when thanks to the value rotation, cheaper stocks were back in vogue.

This year, FOVL has been performing nicely, with price return being the second strongest in the selected cohort.

There is a chance this momentum might persist in 2022 backed by the interest rate increases in the U.S.

Final thoughts

The verdict? I am skeptical about FOVL, though its portfolio scores nicely against the Quant Valuation metrics. The primary reason is its sector composition being out of proportion. I would like to see industrial and materials stocks in the mix. I should mention that a small AUM of only ~$36 million and low volume also pose risks. All in all, FOVL is a Hold.