Value Investing Is Back. But How Do You Choose the Right ETF?

“U.S. markets are inherently biased toward growth, with a heavy emphasis on technology stocks,” says

Matthew Krajna,
co-chief investment officer at Nottingham Advisors.

Recently, though, value has been having a moment and trouncing the richly valued, highflying growth stocks. The S&P 1500 value index is down just 0.2% over the past three months, while the S&P 1500 growth index is down 8.6%. Is it sustainable? Over the past two decades, there have been a lot of false starts for value as a hyperaware Federal Reserve has kept interest rates historically low–effectively bailing out growth investors by making money cheaper. But that isn’t the case now, as the Fed has begun raising rates.

Exchange-traded funds offer many ways to take advantage of this new strength in value shares. The 101 value ETFs on the market offer different approaches for investors: Some track indexes, while others are driven by quantitative, and sometimes active, strategies. Some value ETFs also screen for leverage and earnings, put on sector restrictions and reweight or re-evaluate their portfolios as often as daily.

Adding a value ETF to an existing portfolio requires an understanding of how value fits in. Here’s what to keep in mind when picking a value ETF.

The basics

What is a value stock? Simply put, one that has a low price-to-book ratio (P/B)–a measure of market cap relative to tangible assets. The lower the price-to-book ratio, the deeper the value. Value strategies often overlap with dividend-focused income strategies–because many value stocks are more established companies in traditional dividend-paying sectors such as financial services, consumer companies and healthcare.

Value was solidified as a source of returns in the early 1990s when two University of Chicago professors,

Eugene Fama
and

Kenneth French
(who is now at Dartmouth College), found that higher-book-value companies consistently outperformed the market. Their initial study analyzed returns from 1963 to 1991. Outperformance persisted in an additional study from 1991 to 2019.

Headline-making growth companies haven’t deterred value-minded ETF investors. Through March 31, value-focused ETFs held $409 billion in assets, while growth ETFs held $368 billion, according to FactSet.

Index (and size)

The first consideration for choosing a value ETF is index construction.

To build the S&P 500 value index, for example, S&P Dow Jones Indices evaluates price-to-book, price-to-earnings (P/E) and price-to-sales (P/S) ratios to build a value score. Companies such as

Warren Buffett’s
Berkshire Hathaway,
Procter & Gamble
and
Johnson & Johnson
come up high, contrasted with growth-index leaders
Apple,
Amazon.com
and
Microsoft,
which are scored based on sales and earnings growth and share-price momentum.

The size of companies an index covers–large-cap, midcap and so on–is also important. Messrs. Fama and French’s research also showed that small-cap stocks beat large-caps over the period they studied–but focusing on small companies brings risk.

“Value can pay off particularly well in the small-cap space,” says

Dana D’Auria,
co-chief investment officer at

Envestnet.
“But small value will tend to bring more volatility than large, so investors who are hungry for the payoff of buying at a lower price should consider an all-cap approach that includes those higher-octane small-cap value stocks.”

According to FactSet, there are 30 different U.S. large-cap value ETFs, compared with 10 midcap options, 16 small-cap choices and 20 for total market. For example, Vanguard, iShares and State Street Global Advisors all offer an S&P 500 Value ETF based on the large-cap index, which includes roughly 450 securities. (Other ETFs cover international value stocks.)

Then there’s the issue of the number of constituents in the index. More-inclusive value indexes cast a wide net for stocks, so they often end up including some growth stocks–because those stocks meet some of the criteria for value equities.

So, value ETFs that winnow down the list of potential stocks have holdings with more value characteristics.
Invesco S&P 500 Pure Value
ETF (RPV) culls the value index to just 120 companies, pushing financials to 32% of holdings (compared with 16% for the S&P 500 Value) and delivers a price-to-book of 1.3, compared with 3.1 for the S&P 500 Value (and 8.7 for S&P 500 Growth).

Investors who want to press the value factor can look for highly concentrated ETFs (around 50 holdings) or the juiced returns of leverage. For example,
Direxion Russell 1000 Value over Growth
ETF (RWVG) uses ETFs alongside total-return swaps to manufacture a 150% exposure to the Russell 1000 Value Index and a 50% short exposure to the Russell 1000 Growth Index. (There is also a growth-over-value offering.) Rebalanced monthly, this ETF will exaggerate the spread between the two factors.

But experts warn that the less diversified a value fund is, the greater chance it has of falling into a “value trap.”

“One of the big dangers inherent in value investing is buying low-price stocks only to watch them fall even lower before bottoming out,” says Ms. D’Auria. “One way to protect against this is to incorporate other factor screens, such as quality and momentum, in your value sleeve.”

Multifactor (and more)

ETFs also offer a variety of investment strategies for investors. One common approach is called “multifactor,” which is more dynamic than simply following an index. The ETF is frequently reconstituted or rebalanced, often leaning on factors such as return on equity, profitability and limited leverage.

A handful of ETF managers are pursuing true actively managed ETF strategies, including index-like quantitative strategies that give the manager more discretion. For example,
Avantis U.S. Small Cap Value
ETF (AVUV) holds 630 stocks from the Russell 2000. The ETF can re-evaluate its portfolio daily. It also eliminates regulated utilities and real-estate investment trusts.

Before you choose an approach, experts advise careful consideration–especially if you try to time the market with short-term bets.

Nottingham Advisors’ Mr. Krajna cautions investors: “How far into value do you want to go? Is it a strategic holding–more than three years–or more tactical?”

Mr. Weinberg is a writer in Connecticut. He can be reached at reports@wsj.com.