Are 'Value' ETFs Worth The Risk?

By: Richard Robinson of Street Authority

"Where are the customers' yachts?"

It was a question the tour guide didn't expect. He was taking a group of tourists through the financial district in lower Manhattan from the area now known as Battery Park.

Eventually docks appeared around the park. And because of its proximity to Wall Street, it became a favored location for Wall Street bankers and brokers to dock their very expensive yachts.

So it was on this day that the tour guide was extolling the virtues of Wall Street moneymen. He told his audience that the yachts were the rewards for creating enormous wealth for their customers.

To which one lone voice asked, "Where are the customers' yachts?"

Selling Is More Lucrative Than Buying

Now, I don't know if this story is true. It was described in a book about Wall Street written in 1940 by Fred Schwed. The name of the book is "Where Are the Customers' Yachts?" It's a lighthearted look about a serious subject that every investor should read.

But despite its humorous undertone, the message is dead on. There is far more money in providing financial advice to investors than there is in receiving financial advice from Wall Street experts.

Take the sellers of ETFs, for instance. Exchange-traded funds (ETFs) are one of Wall Street's most popular investment vehicles. They have grown to a $3 trillion dollar industry since their introduction in 1993. They cover nearly every conceivable market sector and niche.

Investors like them because they offer a simple way to buy a basket of stocks. For instance, you can buy every stock in the SP 500 with a single ETF -- the SP 500 ETF (NYSE: SPY).

But fund managers like them, too. That's because they're easy to manage. Investment managers simply select the securities matched to an index and place them into a single portfolio. Since most portfolios are updated annually, the managers really have nothing more to do for the next 12-months -- besides collect the annual management fees.

But buying something simple comes with a price. Many investors assume the managers actively manage the ETFs. But they don't. And the result can be hazardous to your wealth.

This is especially true of "value" ETFs…

'Value' ETFs Provide Little Value

A value stock is one that trades at a discount to its peers based on price-to-earnings (P/E) ratios or other metrics like enterprise value to earnings before interest, taxes, depreciation, and amortization (EV/EBITDA).

Value ETFs are marketed as a basket of companies trading cheaply. But the truth is often quite the opposite. You see, many value ETFs have holdings with wildly inflated valuations. It's a recipe for disaster.

In the tables below, I illustrate the average valuation metrics of the top fifteen holdings of three popular value ETFs: iShares SP 500 Value (NYSE: IVE), Guggenheim SP Small Cap 600 Pure Value ETF (NYSE: RZV), and the Guggenheim SP Mid Cap 400 Pure Value ETF (NYSE: RFV).

Here's what I found…

Each of the ETFs holds a fair number of growth companies. As you may know, growth companies have greater potential for short-term gains. This means they commonly trade at a higher multiple than value stocks.

But the market is so distorted right now that value stocks inside the funds are more expensive than the growth stocks. This should immediately raise a red flag for value investors.

You see, high valuations on value stocks can easily turn into value traps.

Take a look...

IVE has quite a few stocks that can in no way be considered value stocks. You can view its entire portfolio here. ExxonMobil and General Electric have P/E ratios about a third higher than the market. But they pale in comparison to Chevron's P/E of 89.

And it doesn't get any better when looking at EV/EBITDA. Even if you give GE a pass on its 35.9 P/E, there's no way to look past the EV/EBITDA ratio of 25.11. That's three-and-a-half times higher than the ratio for a typical value stock.

The bottom line is that it's a tough sell to convince anyone that IVE is a value ETF.

Now, things do get a little bit better for RZV. While the top 15 holdings have a higher P/E ratio than IVE, the ratio is influenced by two stocks with stratospheric valuations -- Tuesday Morning Corp. (Nasdaq: TUES) at 250 and Calamos Asset Management (Nasdaq: CLMS) at 190.1. If you take out these two stocks, the P/E is a much better 15.6. View RZV's entire portfolio here.

But using the EV/EBITDA metric, RZV sports a reasonable 7.62. This proves the ETF is making good on its promise to find value stocks.

Better yet, this ETF handily outperforms the IVE in one-year and five-year returns.

But let's look at a third ETF…

Collectively, the average P/E and EV/EBITDA of RFV are significantly lower than the previous two ETFs. And the return is comparable to RZV, but with less risk. You can see the whole portfolio here.

What Should An Investor Do?

Don't let Wall Street lull you to sleep with passive investing marketed as value investing.

If you own the IVE, it may be time to consider selling it. It no longer possesses the trademarks of a value ETF. Investors will be better off going to RFV.

It greatly improves the odds of getting your own yacht.

Risks To Consider: Many of the stocks inside value ETFs are growth stocks with great long-term potential. And although many of the stocks inside the ETFs may not be considered value stocks, they may still have significant upside potential. Selling them could impact investor returns.

Action To Take: Consider selling IVE. The fund is overvalued and producing lackluster returns for the risk. Instead, use RFV to gain access to value ETFs. Buy up to $65.00 and set your stop loss at $52.00. Further mitigate any risk by investing no more than 2-3% of your portfolio into RFV.