The Return of Value: How Active ETFs Could Lead the Next Market Cycle

But a new value cycle could be brewing.

The best part is that active ETFs may be the key to unlocking this new cycle while still providing gains if growth keeps it going for a bit longer. Thanks to their ability to find deeper values, lower-priced stocks, and potentially higher dividends, active management offers plenty for portfolios as the new value cycle begins.

It hasn’t exactly been a rip-roaring good time for value investors. Value investors—to quote Warren Buffett—“buy wonderful companies at cheap prices.” Using metrics like price-to-earnings, price-to-sales, and other valuation metrics, investors tend to focus on the unloved and underappreciated stocks within the market. This is different from growth, which bets on stocks growing sales or profits at faster rates than the broader market or sector peers.

Over the last decade or so, growth has been the style of choice for investors.

Following the Great Recession and the years of a meandering economy, investors looking for gains find success in many tech stocks. With high margins and strong cash flows, this investor interest helped growth win out over value. The pandemic accelerated this fact as many tech names became leaders in fields like cloud computing, e-commerce, and work-from-home solutions. Today, the surge in A.I.-related tech stocks has continued to boost growth stocks wins.

For value stocks, that meant plenty of underperformance. This chart from Morningstar sums up the difference, with value stocks posting a 148% return. That’s less than the broader market and about 100 percentage points slower than growth stocks’ total returns.

Source: Morningstar

However, value investors may have the last laugh going forward. That’s because we finally could start to see the shift in investor attitudes and returns. Historically, these shifts have lasted a while.

For one thing, stocks are already expensive when looking at various metrics like forward P/E and return on equity. Today, the S&P 500 is trading at a forward P/E of around 23. That’s pretty expensive considering the long-term average since 1971 is just 17×. Tech stocks? You’re looking at a forward P/E closer to 30.

Data and several research studies conclude that high forward P/Es ultimately reduce long term returns for the market. With stocks expensive, value’s cheaper status and margin of safety work well for better returns. ¹

That margin of safety works well for other economic risks and uncertainty as well. While the Fed has dropped rates, the estimated new neutral rate is expected to be higher. The days of zero interest rate policy (ZIRP) won’t be back anytime soon. This higher base rate scenario bodes well for firms that tend to have better balance sheets, steady sales, and earnings growth. These are hallmarks of many value stocks.

Moreover, economic stability works well for value. Generally, value stocks perform best when the entire economy is doing well, not just one sector. As we approach the soft landing and continue into the maturing business cycle, value stocks have the potential to regain their leadership positions.

With value potentially moving into the pole position ahead of growth, investors want to consider adding the style to their portfolio. However, this is one scenario where indexing may not work well.

The problem with value indexes is they don’t necessarily highlight true values. In fact, looking at many of the main value and growth indexes, there is some significant overlap. They still skew toward the largest firms (i.e., those with more investor interest, bigger market capitalizations, and stronger already-occurred returns). Many of the market’s true values could be further down the S&P 500.

Second, the nature of value has changed. This comes down to sector and stock make-up. Many ‘value’ sectors such as utilities and industrials have quietly become growth stocks in their own right. Automation, software, and renewable energy have all lit a fire under many traditional value sectors. Investors may be able to find growth at cheap prices.

These two reasons scream active management. Active managers can dive deeper into the stock universe, change their weightings, and hold different firms. This allows them to take advantage of real values, different sectors, and even focus on greater ‘guaranteed’ sources of return such as dividends. The margin of safety can be increased.

Active ETFs also provide additional benefits to active managers. The creation-redemption mechanism can push away long-term capital gains taxes, while ETFs can be fully invested. This eliminates cash drag and boosts returns. That’s a huge win for portfolios and investors.

There’s evidence that this plays out. The latest Morningstar active/passive barometer shows that just over half—52.2%—of active value managers beat their passive benchmarks over the last year. Active ETFs, with their lower costs and other benefits, have driven that outperformance. ²

These ETFs were selected based on their exposure to value strategies using active management. They are sorted by their YTD total return, which ranges from 4.7% to 23%. They have assets under management between $210M and $8.6B and have expenses of 0.15% to 0.44%. They are currently yielding between 1.6% and 2.4%.

As fortunes are starting to shift toward value stocks, investors should consider the style of their portfolios. And active ETFs are the correct way to do just that. Ultimately, passive investing fails value investors in a big way, while active management styles can hone in on actual value, boost returns, and make the most out of the upcoming cycle shift.

The cycle between value and growth may once again be shifting toward value’s favor. Higher equity prices and a strong economy are great for value stocks. Active ETFs can play a big role in making sure investors win during the cycle and make the most of their portfolios.

¹ Wharton (August 2023). Why Stock Valuation Hinges More on Returns Than Future Earnings