Most value index funds target the cheaper half of the market, which tends to sweep in a large helping of blend stocks that dilute their value tilts. In contrast, Guggenheim S&P 500 Pure Value RPV targets the cheapest third of the S&P 500 Index and weights its holdings by the strength of their value characteristics. This style purity allows investors to add a value tilt to a diversified portfolio with a smaller investment in this fund than its peers would require.
This approach has generated attractive returns. Over the 10-year period through April 2014, the fund's benchmark -- the S&P 500 Pure Value Index -- outpaced the market-cap-weighted S&P 500 Value Index, which tracks the cheaper half of the S&P 500 Index, by 4.6% annualized. However, part of this performance gap may be due to differences in market capitalization. Because the pure value index doesn't weight its holdings by market cap, it tends to have a smaller-cap tilt. For instance, the average market cap of its holdings (US$19.6 billion) is currently only a fraction of the corresponding figure for the S&P 500 Value Index (US$70.1 billion). During the past decade, the S&P 500 Pure Value Index outpaced the Russell Midcap Value Index by a more modest, but still respectable, 1.2% annualized.
Value stocks have historically outperformed their growth counterparts in nearly every market studied over long time horizons. Because of its deeper value tilt, RPV may be able to capture this premium more effectively than its peers. Its disciplined rebalancing approach also helps. When it rebalances annually in December, the fund increases its exposure to stocks that have become cheaper relative to their peers and trims its exposure to stocks that have become more expensive. These disciplined bets against the market may allow RPV to more effectively capture the mean reversion behind the value effect. However, they may also cause it to overweight stocks with deteriorating fundamentals, which can increase risk.
The S&P 500 Pure Value Index was about 33% more volatile than the Russell Midcap Value Index. It has also tended to underperform during market downturns. In 2008, it lagged the Russell Midcap Value and S&P 500 Value Indexes by 9.4% and 8.7%, respectively. However, this fund may be a suitable satellite holding for investors with a strong risk tolerance.
Fundamental view
In the United States, large- and mid-cap value stocks have outpaced their growth counterparts by approximately 2.5% annualized from 1927 through 2013, according to data from the French Data Library. Efficient-market advocates argue that this performance gap is compensation for risk. This risk story is plausible. Value stocks tend to have less attractive business prospects than their growth counterparts, which may justify their lower valuations. They are also less likely to enjoy sustainable competitive advantages. Many of the fund's holdings, such as 
Staples SPLS and Hewlett-Packard HPQ, face significant competitive pressures that could limit their profitability and growth.
On average, RPV's holdings generated a lower return on invested capital -- 5.5% over the 12 months through April 2014 -- than Guggenheim S&P 500 Pure Growth's RPG holdings (13.3%). Not surprisingly, they have also been growing at a much slower clip. Analysts expect this gap to narrow but continue during the next five years, according to consensus estimates collected by Morningstar. Investors may demand higher expected returns to hold these less desirable companies.
Yet, investors may penalize these value stocks too much by extrapolating recent performance too far into the future. This myopic focus can push prices below their fair values. Consequently, value stocks have generated better risk-adjusted returns than the market over the long run. Their depressed valuations can provide a margin of safety and attractive upside if they exceed expectations, which are low to begin with.
But because they often face dim business prospects, value stocks can be difficult to own. Some of these companies may look cheap, but become cheaper as their fundamentals deteriorate. That's enough to make many investors nervous. Even if stocks are in fact undervalued, they can remain out of favour for years. This makes it difficult to eliminate the value premium through arbitrage. Consequently, it likely will persist.
While it is generally a good idea to own stocks that are cheap, historically it has been a bad idea to buy stocks after a recent period of poor relative performance. That's because recent performance tends to persist in the short term. This phenomenon is known as momentum. Most value strategies implicitly bet against momentum because they tend to overweight stocks that have recently underperformed. RPV has greater exposure to stocks with negative momentum than most of its peers because it weights its holdings according to the strength of their value characteristics. Stocks that have become cheaper between rebalancing dates tend to have poor relative performance. However, the fund increases its exposure to these stocks when it rebalances. This may erode the potential return advantage from the fund's deep value tilt.
At the end of April, RPV was trading at a price/forward earnings multiple of 13.8, while the corresponding figure for its growth counterpart was 20.0. Differences in expected growth rates may justify part of this gap. However, as of this writing, the fund also looks a little cheaper based on Morningstar equity analysts' fair value assessments of its underlying holdings. RPV is currently trading at a lower price/fair value multiple (1.00) than Guggenheim S&P 500 Pure Growth (1.06). Its holdings may also have a better chance of beating expectations.
Portfolio construction
The fund employs full replication to track the S&P 500 Pure Value Index. S&P assigns composite value and growth scores to each stock in the S&P 500 using three growth metrics (12-month price momentum, three-year change in earnings scaled by price and three-year sales per share growth) and three value metrics (price/book, price/sales and price/earnings). It ranks each stock by the ratio of its growth score to its value score and selects those with the lowest ranks for the pure value index until it represents a third of the assets in the S&P 500 Index. While the index weights each constituent according to the strength of its value characteristics, it caps these weightings to improve diversification. Because the index only rebalances once a year, it may experience a little style drift. Relative to the market-cap-weighted S&P 500 Value Index, the fund overweights financial services and utilities stocks, and underweights the health-care, industrial and consumer defensive sectors.
Fees
RPV levies a 0.35% expense ratio, which is a bit higher than traditional market-cap-weighted index alternatives. It may also have higher turnover than a traditional value index fund, which can create higher transaction costs. Guggenheim generates some ancillary income for the fund through securities lending, which helps partially offset its expenses. During the past three years, the fund has lagged its benchmark by 0.52% annualized.
Alternatives
IShares Morningstar Large-Cap Value JKF (0.25% expense ratio) is one of the closest alternatives. Similar to RPV, it excludes large-blend stocks and targets the cheapest third of the U.S. large-cap market. However, in contrast to RPV, it weights its holdings by market capitalization, which gives it a larger market-cap orientation. It also rebalances more frequently (quarterly) in order to mitigate style drift.
Vanguard Mid-Cap Value VOE (0.09% expense ratio) offers similar market-cap exposure to RPV. It targets the cheaper half of the U.S. mid-cap market and weights its holdings by market capitalization. While this broader reach sweeps in some blend stocks that dilute the fund's value tilt, it also helps temper volatility. Vanguard Value VTV (0.09% expense ratio) and iShares S&P 500 Value IVE (0.18% expense ratio) offer similar market-cap-weighted exposure to the cheaper half of the large-cap market.
The Toronto-listed PowerShares FTSE RAFI US Fundamental CAD-Hedged PXU, which holds units of the U.S.-sold PowerShares FTSE RAFI US 1000 PRF, offers an alternative way to tilt toward value. It offers broad exposure to the market, but weights its holdings on fundamental measures of size, including sales, cash flow, dividends, and book value. Similar to RPV, this fund increases its exposure to stocks that have become cheaper relative to these metrics when it rebalances and trims back on stocks that have become more expensive. However, because of its broader portfolio, PXU has less exposure to stocks with negative momentum.
Disclosure: Morningstar Inc.'s Investment Management division licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Neither Morningstar Inc. nor its investment management division markets, sells or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.
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