What upcoming index changes mean for two factor ETFs

BlackRock is switching benchmarks for two of its U.S.-listed factor ETFs, but this change may help one ETF more than the other.

Alex Bryan 28 July, 2015 | 5:00PM

In 2013, BlackRock launched iShares MSCI USA Value Factor (VLUE) and iShares MSCI USA Quality Factor (QUAL) to offer low-cost access to U.S. stocks with characteristics that have historically been associated with higher returns. Because some sectors naturally have a greater concentration of stocks with low valuations and strong quality characteristics than others, these funds introduce sector biases that investors may not intend. In order to address this potential issue, BlackRock recently announced that it is changing QUAL's benchmark from the MSCI USA Quality Index to the MSCI USA Sector Neutral Quality Index at the end of August 2015. At that time, it will also switch VLUE's benchmark from the MSCI USA Value Weighted Index to the MSCI USA Enhanced Value Index, which is also sector-neutral. This change does not make QUAL any more or less compelling, but it is a meaningful improvement for VLUE.

In the original quality index, MSCI assigns quality scores to each stock in the broad MSCI USA Index. These scores are based on return on equity, debt/capital and variability in earnings growth over the past five years. It then selects the top-scoring stocks, regardless of sector membership, and weights them according to both the strength of their quality characteristics and their market capitalization. This currently gives QUAL greater exposure to the technology and consumer cyclical sectors than the MSCI USA Index and less exposure to financial services, utilities and telecom stocks.

The sector-neutral version of the quality index assigns sector-relative quality scores to each stock in the MSCI USA Index. This puts stocks from different sectors on a level playing field. For example, a stock in the energy sector could receive a higher sector-relative quality score than a tech stock with even stronger absolute quality characteristics, if the tech stock looks less remarkable relative to its sector peers. MSCI then selects the top-scoring stocks regardless of sector classification until it reaches a predetermined target number of stocks, representing around 30% of the market capitalization of the parent index. Stocks that make the cut receive weightings according to both their sector-neutral quality scores and market capitalization. On the semiannual portfolio reconstitution dates, MSCI matches the portfolio's sector weightings to the MSCI USA Index's and rescales the constituents' weightings in each sector to achieve that objective.

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About Author

Alex Bryan

Alex Bryan  Alex Bryan, CFA, is director of passive strategies for North America at Morningstar. Before assuming his current role in 2016, he spent four years as an analyst covering equity strategies. He holds an MBA with high honors from the University of Chicago Booth School of Business.

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