Is there enough ‘Value’ in your equity ETF?
Equity markets appear to have shifted to a new regime following the announcement of successful COVID-19 vaccines in November 2020. Since then we have seen ‘value’ stocks outperform following a lengthy period of underperformance. We believe this trend of ‘value’ outperforming is set to continue and, for ETF investors, knowing the style biases in an ETF can help understand performance patterns. In this blog we take a closer look at the style exposures in our equity ETFs, the Russell Investments High Dividend Australian Shares ETF (RDV) and the Russell Investments Australian Responsible Investment ETF (RARI), and review their recent index reconstitutions.
By design, there is a ‘tilt to dividend yield’ in both RDV and RARI. Stocks with above average dividend yields will typically have ‘value’ characteristics i.e. they trade on relatively low valuation multiples, and since both RDV and RARI favour high yield stocks the ‘value’ skew in their portfolios is intuitive.
Style scores at 1 April 2021 (post index reconstitution):
Source: Russell Investments, Z scores using Russell Investments risk model
There is a clear overweight value and underweight growth positioning for both ETFs.
ESG style risks
Last year in a research note titled 'The Unintentional Biases of ESG Portfolios', Kris Nelson, Director, Investment Research at Russell Investments, found that some measures of ESG risk tend to correlate with other drivers of returns, including size, style and region. Portfolios that are focused on minimising ESG risk could create a portfolio that is biased towards growth, developed markets and large cap companies. This growth bias from large cap stocks such as Tesla has helped many ESG funds outperform in recent years.
Russell Investments’ manager research team maintains an ‘ESG Managed’ universe of over twenty externally managed Global Equity strategies that have a stated ESG outcome. Over three years to 31 December 2020, the Russell ESG Managed median strategy outperformed by 6% p.a. - delivering a 15.61% p.a. return, compared to 9.58% p.a. return for the broader Russell global equity strategy set1. However, market dynamics are changing which more recently has favoured value over growth stocks and this has resulted in a more challenging environment for many ESG strategies.
How has RARI faired?
Unlike some ESG based ETFs listed on the ASX which have a heavy growth bias, the equity holdings in RARI have a ‘value’ tilt. This has helped RARI outperform the S&P/ASX 200 in the 5 months to 31 March 2021 – the period following the vaccine news that has favoured Value style strategies.
We reconstituted RARI on 31 March and the new portfolio has maintained a value-oriented theme.
We further enhanced our fossil fuel exclusion with an Oil & Gas revenue threshold that resulted in sells in APA Group and Ampol. RARI now has nil exposure to the Energy sector and is underweight the Utility sector. Full details of the reconstitution are shown below:
Source: Russell Investments as at 26 February 2021.
The biggest beneficiaries of the reconstitution were the Financials and Materials sectors. There were several new buys in the Materials sector including mining services provider Mineral Resources which has an above average ESG score and superior dividend credentials. We also remain overweight Fortescue Metals which scores well on ESG and dividend factors too. The dividend outlook for Financials continues to improve and the increased weight to the sector helped maintain the overall value tilt in the portfolio.
Portfolio turnover was higher in RDV at 23.8% (versus 16.8% for RARI) and we saw larger moves at the sector level.
Source: Russell Investments as at 26 February 2021.
The reduction in Financials exposure in RDV was driven by a 3% sell of Bank of Queensland (BOQ) which had risen to 5% of the portfolio following a capital raise to buy ME Bank. The deal was well received by the market which resulted in the stock price jumping. RDV sold BOQ shares at the reconstitution 17.7% higher than the price paid for new shares in the capital raise a month earlier.
On the buy side there was a very cyclical flavour to the new stocks added to RDV, and we expect the cyclical part of the market to perform well as the economy continues to recover from the COVID-19 pandemic. RDV bought Mineral Resources within the Materials sector and there were new buys in Rio Tinto and Alumina that are also expected to pay dividends higher than the market average. In addition, new adds in Boral and Iluka Resources reflect expectations for the companies to resume dividend payouts and the prospects of strong dividend growth as the economy expands.
The style exposures of portfolios can strongly influence investment returns both in a relative and absolute sense. Many ESG based funds have benefited from an unintended growth bias in their portfolios, which has contributed to their outperformance due to market environment tailwinds.
In the near term, the investment landscape looks set to favour more value-based portfolios as economies continue to recover from the pandemic, helped by high levels of government stimulus across the globe. Given we are at the early stage cycle of economic recovery, ETF investors should ‘look under the bonnet’ of their ETF portfolios to better understand the style risks they are exposed to, as they may no longer be aligned with the macroeconomic outlook.
1 Source: Russell Investments