VUSE - VUSE: Focused Strategy With Appealing Valuation But Inconsistent Returns

2023-06-06 05:21:20 ET

Summary

• VUSE focuses on U.S. companies with "high-quality governance and management standards that are trading at reasonable valuations relative to the market."
• The article delves into VUSE’s current factor mix.
• VUSE represents yet another example of a fundamentals-driven, meticulously calibrated strategy that cannot beat IVV consistently.
• Though I view its profitability characteristics as being unquestionably solid, I believe a Hold rating is appropriate here.

Vident U.S. Equity Strategy ETF ( VUSE ) is a passively managed fund focusing on U.S. companies with "high-quality governance and management standards that are trading at reasonable valuations relative to the market." There are profitability and momentum considerations as well. The fund has an AUM of ~$516 million, which is a fairly solid result amassed since its inception in January 2014. The expense ratio is at 50 bps as the complicated strategy welcomes higher fees.

VUSE showed resilience last year amid the inflation-driven bear market, but the longer-term total returns look fairly bleak, with the compound annual growth rate delivered since its inception being substantially below the one clocked by the iShares Core S&P 500 ETF ( IVV ). On the positive side, it is valued attractively compared to the market as illustrated by the earnings yield, with quality characteristics being nothing short of robust. However, there are other considerations investors should pay attention to. Let me elaborate on that below.

VUSE strategy: nuanced and meticulously calibrated

According to the ETF's website , the cornerstone of VUSE's strategy is the Vident Quality U.S. Stock Index, which is rebalanced and reconstituted on a biannual basis (February and August). The fact sheet provides a succinct explanation of what the fund pursues:

The application of Vident's investment methodology seeks to produce a portfolio with exposure to companies with high-quality governance and management standards that are trading at reasonable valuations relative to the market.

To achieve that, as described in the summary prospectus , the universe of eligible U.S. companies is screened using the proprietary corporate governance score. The index is constructed with attention paid to the market cap factor which influences constituent weights as the universe is divided into the giant, large, and small/mid cap segments. Quality and momentum indicators are also incorporated into the multi-factor model that impacts weighting. For example:

For stocks in the Giant and Large market cap segment, quality is defined as profitability and profitability growth. The components account for current and historical gross profits, return on invested capital, cash flows, and margins of companies in each segment.

According to page 5 of the summary prospectus, the fund underwent strategy changes in the past. First:

Effective December 31, 2022, the Fund's investment objective changed to track the performance, before fees and expenses, of the Vident U.S. Quality Index. From January 6, 2016, to December 30, 2022, the Fund's investment objective was to track the price and total return performance, before fees and expenses, of the Vident Core U.S. Stock Index.

And second:

Prior to January 6, 2016, the Fund's investment objective was to track the price and total return performance, before fees and expenses, of the Vident Core U.S. Equity Index.

Since the strategy description is rather voluminous and nuanced, I recommend my dear readers referring to page 1 of the prospectus where it is reviewed in much greater depth.

What factor mix should investors expect?

As of June 5, VUSE had a portfolio of 130 holdings (excluding cash), with the principal ten stocks accounting for about 23.8% of the its assets. The ETF has exposure to all the eleven GICS sectors, with the top trio being IT, consumer discretionary, and health care. The table below compares its sector allocation to IVV's.

Created using data from IVV, VUSE, and iShares Russell 3000 ETF ( IWV )

As it can be seen, the differences are rather small, with VUSE being overweight in five sectors (financials being most significant, by 1.5%) and underweight in six (most notably IT, by 2.7%).

As the fund's strategy pays attention to quality, its profitability characteristics are almost perfect. The following facts (the weighted-average figures were computed by the author) support that point:

1. VUSE has ~96.4% allocated to stocks and REITs having the strongest quality characteristics in their respective sectors (no less than a B- Quant Profitability grade). None has underlying issues worrisome enough for a D+ rating or worse.
2. Unprofitable companies are almost absent, with the exception being Pinterest ( PINS ), a company that hardly needs a lengthy introduction; the stock has a 25 bps weight in the fund. It should be noted that despite being loss-making on an LTM basis, Pinterest has positive cash from operations, even with a cash surplus (known as FCF).
3. The weighted-average net income margin is ~22.7%, an exemplary result.
4. Cash-burning companies are not represented in this portfolio (excluding financials), at all.
5. Earnings quality, an indicator I compute by dividing the net operating cash flow by GAAP net income (there are other definitions not to be detailed in the today's note), also signals this mix is fairly robust as 89% of the net assets are allocated to the holdings with that ratio above 1x.
6. Data on returns on capital are also unambiguously encouraging. First, Return on Equity exceeds 47%. My dear readers may justly ask here about whether VUSE has exposure to overleveraged names with ROE skewed by the debt burden. And I should note that it has, with, for instance, debt-heavy Fortinet ( FTNT ) and Marriott International ( MAR ) having 85 bps and 95 bps weight, respectively. But there is a caveat. A more reliable Return on Assets metric is over 15%, which is a pleasant surprise. The greatest contribution to that figure was made by 28 stocks (19% of the net assets) that managed to deliver an over 20% ROA, with Cal-Maine Foods ( CALM ) and Encore Wire ( WIRE ), accounting for 33.9% and 38%, respectively, influencing that figure significantly.

Growth exposure also deserves a separate discussion:

1. VUSE's growth characteristics, if measured using the weighted-average metrics based on analyst forecasts, are acceptable, but not spectacular.
2. For example, the earnings per share are forecast to grow at a 9.7% rate portfolio-wise.
3. On a side note, this obviously does not mean there are no EPS contraction stories in this mix. They are meaningfully represented (~21.5%).
4. Meanwhile, sales could demonstrate even slower dynamics, with only around 7% forward growth rate.

Now, the value component. On the VUSE website, it is said that the fund favors companies that are "trading at reasonable valuations relative to the market." Are they? Mostly yes, but there are nuances. VUSE's portfolio is valued at a discount to the market (proxied with the S&P 500 index) as indicated by its earnings yield of ~6.5% vs. ~4.8% of the bellwether index. It is also boasting a rather strong cash flow yield of ~8.2% (the net CFFO/market cap), with the principal contributors being Alpha Metallurgical Resources ( AMR ), a met and thermal coal mining firm, Matson ( MATX ), a marine transportation company, and the above mentioned food industry player CALM, which have enormous cash flow margins.

However, when it comes to more nuanced sector-wise valuations, the ETF does not look that alluring, as 76.5% of the holdings have a D- Quant Valuation grade or worse, which indicates they are priced at a premium to their sectors and historical averages.

Does VUSE deliver?

VUSE's elegantly designed strategy with robust quality exposure in the current portfolio iteration looks intriguing, but does it deliver? First, let us look at its returns during the February 2014 - May 2023 period juxtaposed to the performance of IVV.

Created by the author using data from Portfolio Visualizer

Over that period, VUSE underperformed IVV by around 3.4% (assuming the compound annual growth rates). More specifically, it outperformed IVV only three times, in 2016, 2021, and 2022, with the latter being the strongest year as it bested IVV by 8.7% (yet it was still down by 9.4%).

Next, in the past, I covered a few quality-centered ETFs from which I picked ten for comparison purposes (including actively managed, those focused on foreign equities, etc.).

In the selected group, VUSE delivered the six-month, YTD, and five-year returns either in line or below the medians (with data as of June 4). At the same time, it grossly beat all its peers over the past three years. It should be noted that it had a phenomenal 2021 when it advanced by 35.5%, so the three-year figures reflect that.

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