META - AVLV: Add A Quality Tilt To Your Broad Market Index Funds With This Active Large Cap ETF

2023-11-24 09:00:00 ET

Summary

• AVLV is a relatively new, actively managed Value ETF that should be particularly attractive to index fund investors concerned about the dominance of the Magnificent Seven.
• We explore the nuanced methodology used by AVLV's managers to select and manage its stocks and explore how its unusual, flexible market cap weighting plays out in its actual holdings.
• There are some risks, which we detail, but overall, this could be a great place to put new funds in today's very uncertain economy.

I've come to the conclusion that the best investment for a buy and hold investor like me is a broad market index fund. I figure that if Warren Buffett thinks a broad market index fund like the S&P 500 ( SP500 ) is good enough for his wife to invest in after he is gone, it would probably work for my kids. The bulk of my stock investment is now divided between the Vanguard Total Stock Market ETF ( VTI ) and the Vanguard S&P 500 ETF ( VOO ).

But over the past year, I've become troubled by the degree to which both of these ETF's gains have been driven by the performance of a handful of stocks, the so-called "Magnificent Seven." These stocks, Apple ( AAPL ), Alphabet ( GOOG ) ( GOOGL ), Amazon ( AMZN ), Meta Platforms ( META ), Microsoft ( MSFT ), Nvidia ( NVDA ), and Tesla ( TSLA ), are currently priced at levels that assume that they will continue to achieve the kind of aggressive earnings growth characteristic of much smaller, more dynamic companies.

This is concerning. These stocks are now, with the exception of Tesla and possibly Nvidia, mature companies that have already expanded into all available global markets. We could reasonably expect to see their future annual earnings grow at rates around 10%, rather than at far higher rates their current multiples imply. (Tesla has more markets to expand into but it has its own unique issues which would require an article of its own to explore. Suffice it to say I don't particularly want to depend on it for a significant part of my future stock returns.)

So I have been searching for ETFs that might be a good place to invest new money right now. In particular, I'm looking for ETFs that might be expected to perform better than the S&P 500 should we finally get the recession that experts have been predicting for the last three years. But I'd also like to find one that would not perform poorly when the broader market - not the Magnificent 7 - were to recover quickly.

My Hunt for an Alternative Broad Market ETF Came up with a Tempting Active Value ETF

I've always liked the concept of value investing. I have always avoided investing in Value ETFs because I didn't think their holdings matched what I think of as value investments. That was wise. Investing in Value ETFs has been a great way to miss out on most of the market gains achieved during the period when interest rates hovered just above 0%.

The chart below compares the total return of the Vanguard Value Index Fund ETF ( VTV ) with that of VOO and makes VTV's underperformance painfully clear.

VTV vs VOO Total Return November 2013 - Now

Investors in VTV have earned 30% less total return over the past 10 years than did those who stuck with Buffett's advice to invest in the S&P 500.

But this backtest would mislead you if it made you conclude that true value investing is a poor way to invest. That's because the way that Vanguard selects stocks and retains those stocks in its Value Index Fund ETF is too crude to identify stocks that are, in fact, mispriced for their future earning potential . That highlighted phrase is the actual definition of value. I have analyzed the Vanguard Value Index Fund's methodology in detail and pointed out the flaws inherent in its over-simplistic, mechanical way of picking out stocks in an earlier article which you can read here.

So I was very interested when I learned that there was a relatively new active Large Cap Value ETF that takes a more nuanced approach to finding high-quality stocks that are underpriced for their potential earning power. That ETF is the Avantis US Large Cap Value ETF ( AVLV ).

Since its inception on September 23, 2021, AVLV has performed decently under various market conditions. You can see this in the chart below, where I have compared it with the Vanguard Value Index ETF, VOO, and the other broad market ETF that many investors select when they want an ETF that they believe screens for value, the Schwab U.S. Dividend Equity ETF ( SCHD )*.

AVLV Compares Favorably with VTV, VOO, and SCHD Since Inception

Let's do a Deep Dive into AVLV's Methodology

I have seen AVLV discussed very superficially in various articles published in the Financial press and online, but none go into the details of what differentiates AVLV's methodology from that of other Value ETFs. It's an active ETF, which means that it doesn't just track an index, so we can't just look up its index to see how it evaluates, buys and sells stocks. Fortunately, its prospectus goes into more detail than is usual for an ETF about how it selects and manages stocks.

Here's what that prospectus tells us:

To identify companies with higher profitability and value characteristics, the portfolio managers use reported and/or estimated company financials and market data including, but not limited to, shares outstanding, book value and its components, cash flows from operations, and accruals. (Emphasis mine)

To elaborate on this the prospectus explains:

The portfolio managers define value characteristics mainly as adjusted book/price ratio (though other price to fundamental ratios may be considered). The portfolio managers define profitability mainly as adjusted cash from operations to book value ratio (though other ratios may be considered). (Emphases mine)

The portfolio managers may also consider other factors when selecting a security, including industry classification, the past performance of the security relative to other securities, its liquidity, its float, and tax, governance or cost considerations, among others. (Emphases mine)

The various phrases I have emphasized above point out where AVLV's active management can provide the flexibility, informed, timely judgement, and just plain common sense that passive indexes cannot. Though there is a methodology to be followed, as is described in its pages, the prospectus makes it clear that AVLV's managers will be able to use their human brains to go beyond the dry reported numbers when selecting, or as we will see, eliminating a stock from the ETF.

AVLV Weights its Holdings the Way a Rational Investor - Not an Algorithm - Would Weight Them

AVLV is not slavishly market cap weighted. It has a market weight tilt but one that the managers can override. As the prospectus explains:

...the portfolio managers use the market capitalization of the security relative to that of other eligible securities as a baseline, then overweight or underweight the security based on the [valuation] characteristics described above.

This immediately differentiates AVLV from all the ETFs I compared it to above which are purely market cap weighted. SCHD goes so far as to rank all the stocks it holds using its valuation parameter and then once its stocks are chosen, ignores their quality ranking and weights its stocks entirely by their market cap, just like VOO, VTI, and most other broad market ETFs.

AVLV isn't Bound to only Adjust Holdings on a Preset Date

Unlike passive indexed ETFs that only reconstitute their holdings once a year or when a stock catastrophically fails to meet their inclusion criteria, AVLV's managers can eliminate a stock at any time when it no longer meets the very flexible capitalization, profitability, and value criteria they use to select stocks.

AVLV Uses a Very Broad Definition of "Large Cap"

AVLV's definition of "Large Cap" stocks is also broader than that used by the S&P 500. The S&P 500's selection criteria for its Large Cap stocks now requires that a stock to have a minimum market capitalization of $13 billion to be considered for inclusion in its index, though the S&P 500 does hold stocks with smaller market caps if they meet the criteria when they were added to the index and have seen their prices drop since.

AVLV's prospectus tells us that:

The fund defines large capitalization companies as those with market capitalizations at least as large as the smallest company in the Russell 1000® Value Index. Though market capitalizations will change from time to time, as of September 30, 2022, the market capitalization of the smallest company in the Russell 1000® Value Index was approximately $271.14 million.

Hence though AVLV's title states that it is a large-cap ETF, it appears to be able to invest in profitable, well-valued Mid-Cap stocks too. Better still because the weighting of a stock in AVLV can be adjusted by the managers based on its value characteristics, a Mid-Cap stock's contribution to the value of the total ETF can be higher than it would be in a passive broad market Value ETF where only the stocks ranked in the top half of the ETF's holdings make up more than a tiny percent of the ETF's entire value.

AVLV's Current Holdings Impress

The top 10 holdings of AVLV look familiar to anyone who follows the stock market and is familiar with the S&P 500's top holdings. But their weightings do not. Apple is there in the top 10, as are Meta and Alphabet, but their weightings in AVLV are about half of what we see in the S&P 500. The total weight of these top stocks in AVLV is 20.54%. That's a third less than the 31.96% that the top 10 stocks make up in the S&P 500 .

AVLV's Top 10 Holdings as of November 21, 2023

Source: Avantis

Also, it is interesting to note that AVLV does hold several other stocks that are found in the Top 10 of the S&P 500, like Amazon and Johnson & Johnson ( JNJ ), but they don't make it into AVLV's top 10 because they make up a much smaller proportion of its total value here than they do in the S&P 500. Amazon is only 1.31% of AVLV's total value, less than half of the 3.48% weight it has in the S&P 500. This makes it clear that the managers of AVLV do use their discretion when weighting stocks in the ETF.

AVLV Holds Fewer Stocks than the S&P 500 But Only the Top 100 are Significant

I always like to look beyond the top 10 stocks in an ETF. Here is a list of the top 50 stocks held by AVLV for you to examine. They look like stocks I'd be willing to own and they look a lot like what I came up with the last time I scanned stocks for value characteristics. They are not deep value by any means, but they are profitable stocks whose P/E ratios are modest compared to the likes of Tesla with its current P/E ratio of 75.88.

Top 50 Holdings of AVLV as of November 21, 2023

AVLV only holds 263 stocks. This is significantly fewer than the Vanguard Value Index Fund ETF's 345. But as is the case with almost all the ETFs, you could eliminate most of the stocks that fall in the bottom quarter of their holdings when ranked by weight and still get the identical results from your investment.

Here is how value is concentrated in its holdings when they are ranked by weight in the ETF:

• 20.54% fall in the Top 10
• 39.02% fall in the Top 25
• 58.55% fall in the Top 50
• 80.00% fall in the Top 100
• 1.40% fall in the Bottom 50

All in all, it seems to me that AVLV might be among the very best defensive long, broad market ETF investments you could make if you believe that the most popular market cap weighted ETFs like the SPDR S&P 500 ETF Trust ( SPY ) and VOO will pay a high price for their current over-concentration in the "Magnificent Seven" when we get the next, inevitable market downturn.

How Big is AVLV?

Because AVLV is relatively new, the prudent investor will want to know how large and how actively traded it is. Currently, it has $1.7 billion of assets under management. This is not bad for a newer ETF, but it is far smaller than the $92 billion that VTV has attracted or even the $7 billion Avantis US Small Cap Value ETF ( AVUV ) has attracted.

Seeking Alpha gives us these statistics about AVLV's liquidity:

These numbers suggest that AVLV trades enough to be viable at least for the next few years. Avantis tells us its 30-day average bid ask spread is .04% and its premium/discount as of November 20, 2023 was .02%. These are acceptable too. Its expense ratio is a very reasonable .15%, too. This is only .10% higher than VTV's expense ratio. That works out to an additional $1/year per $1,000 invested. You will pay a higher expense ratio to invest in Vanguard's actively managed funds. Vanguard Equity Income Fund Investor Shares ( VEIPX ) has a .28% Expense Ratio.

What Risks Do You Face When Investing in AVLV?

AVLV Could Develop Cash Drag

AVLV's prospectus tells us that the ETF will invest at least 80% of its assets in large-cap stocks. Lest this raise the specter that 20% of cash you invest in it might end up sitting on the sidelines. But as of now, AVLV is fully invested with a negative cash balance of 0.13%

It is possible that under some market conditions, the managers might go to cash to give them the resources to acquire quality stocks whose prices have tumbled to where they represent superb value investments.

I consider this to be a plus, because I'm not crazy about the valuation of even the best-looking value stocks right now. If we have a serious recession there will be much better values and I would hope that the managers of AVLV would move to cash early enough to be able to take advantage of them. That cash balance, however, is something to keep an eye on if you are thinking of investing it AVLV.

AVLV's Managers Might Do Dumb Things

Active ETFs were investors' darlings when Cathie Wood's ARK Innovation ETF ( ARKK ) was flying high. But as we have seen, Wood has made some unfortunate investment decisions since her ETF's heyday in early 2021. That cautionary tale raises two questions: Who are AVLV's managers and how sound are their judgments?

Avantis is a division of American Century Investments a company that has been providing mutual funds since 1958. Morningstar awards American Century Investments 3 stars.

Avantis' Stock ETF Managers All Come from Two High-Quality Mutual Fund Companies

The senior portfolio managers of its Avantis division are profiled on the Avantis website though there is no indication of which funds are managed by which managers. What stands out is that they all have significant experience working for one of two very well-known firms, highly respected for their nimble active mutual funds, Dimensional Funds Advisors (DFA) and Pacific Investment Management Company (PIMCO).

DFA pioneered factor investing. For years its funds were only available to people whose money was managed by professional managers, though they have recently launched their own suite of ETFs. Pimco's very actively managed income products have racked up very good track records, too.

This suggests that the people managing Avantis funds including AVLV have high-quality experience - unless, of course, they were fired by their previous firms for incompetence, which is something we would likely never find out. But my guess is that this is not the case and that Avantis lured away some of these other company's ambitious managers by offering them a chance to do things their way - and a lot more money.

That said, how good their management really is only something we can learn going forward.

The Market Might Continue to Be Dominated by the Magnificent Seven's Gains

We saw earlier how Value investing via the most popular ETF in that sector, VTV, robbed a lot of investors of a third of the gains they could have earned had they invested in an ETF that tracked the S&P 500. They would have done even better investing in the Invesco QQQ Trust ( QQQ ). The stocks driving these gains were not value stocks. There is no guarantee that this won't continue to be the case. In that case, any time investors chase growth at any price, an investment in even the best-designed value index will lag.

Avantis Might Close Down AVLV if it Doesn't Prove Profitable Enough

There is always the chance that any ETF that doesn't attract many billions of investor dollars will be shut down. That could be a concern for AVLV. Avantis US Small Cap Value ETF has been far more popular than its Large Cap offering and has attracted more than 3 times as many investment dollars as AVLV. This is probably because there is a strong cohort of investors who believe that Small Cap Value will outperform the market as a whole in the long term. I don't agree, but I'm not a professor of Economics.

The reason I don't agree is that the belief in the superiority of Small Cap Value stems from a study published in 1993 by professors Eugene Fama and Kenneth French " Common risk Factors in the returns on stock and bonds ," which used backtesting to come up with the finding that Small Cap Value would outperform.

Since that paper's authors were awarded the Nobel Prize in Economics, Small Cap Value has not outperformed Large Cap. But the academically influenced faithful are still waiting. My take on this is that Fama and French's study was based on backtesting stock behavior throughout a pre-computer period when the stock market was very different from today's. Small companies did not IPO with prices in the multi-billions in the 1980s as they do now, when private equity keeps growing small companies private for longer than used to be the case.

But whatever the merits of Small Cap Value Investing value-focused investors might continue to spurn Avantis' Large Cap Value offering - AVLV in favor of its Small Cap Value AVUV. If this persists and AVLV does not continue to grow its assets, there is some risk that AVLV might fold. This could be a serious problem if you held AVLV in a taxable account and had significant capital gains. The threat of closure is one issue that investors in the mega-ETFs like SPY, VOO, VTI, or QQQ don't have to worry about.

Bottom Line: AVLV is a Great Place to Put New Money in the Current Environment

For the Buy and Hold investor uncomfortable with how the best-known broad market index funds have become so dominated by the Magnificent Seven, AVLV is an excellent choice as a place to invest new money that you want to put to work in stocks right now.

If the market continues to rise, it has enough of the major stocks found in the other broad market indexes that you will see gains, but if the overvalued Tech stocks crash thanks to a prolonged recession, AVLV might in the worst case lose considerably less than SPY, VOO, VTI, or QQQ and in the best might adapt quickly and be able to load up with high-quality stocks when their prices have dropped enough to make them great investments. And when the market does plunge, which we know now tends to drag down the prices of all stocks no matter how well valued, at the very worst, you are likely to lose less than the broader passive indexed ETFs and be able to tax loss harvest back into them after things begin to settle down.

Nevertheless, because there are significant risks I would not treat AVLV as a replacement for the other, broader passive Large Cap indexes. It's a supplement to them that gives your portfolio a true value tilt. For now, I'm investing small amounts in AVLV as new money becomes available and watching its behavior. If it does do well when other ETFs investors have bought for a value tilt do not, and becomes popular and investors bid up its price, having bought in now while it is relatively small and unknown could give you an additional advantage.

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*As I have explained in previous articles , SCHD doesn't actually screen for value. It screens for the ability to pay dividends which is only one step towards a comprehensive value screen.

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