The other day, I was thinking about the relatively high valuations of U.S. equities. It made me think of doing a review of different large exchange-traded funds (ETFs) across the U.S. large value category. We had also noticed Morningstar’s recent positioning of the WisdomTree U.S. Quality Dividend Growth Fund (DGRW) in their style box map, so we included it in the comparison.

When I start looking at strategies, I try to simplify the picture into three things:

• Average annual returns, preferably over a period of greater than 10 years, if possible.
• Average annual volatility, to give a sense of the experience of generating those returns.
• Average annual Sharpe ratio, to measure the units of return in excess of a risk-free rate, relative to the level of volatility.

We see the results in figure 1a.

Figure 1a: A Performance Snapshot of Different U.S. Value Equity ETFs

To help with further context:

• DGRW is designed to track the total return performance, before fees and expenses, of the WisdomTree U.S. Quality Dividend Growth Index. This strategy focuses on dividend-paying companies, weighted by their cash dividends, and prioritizes companies with higher return on equity (ROE), return on assets (ROA) and earnings growth expectations.
• IVE, the iShares S&P 500 Value ETF, is designed to track the total return performance of the S&P 500 Value Index. This index focuses on the value segment of U.S. large-cap equities.
• IWD, the iShares Russell 1000 Value ETF, is designed to track the total return performance of the Russell 1000 Value Index. The index focuses on the value segment of U.S. large-cap equities.
• VTV, the Vanguard Value Index Fund ETF Shares, is designed to track the total return performance of the CRSP U.S. Large Value Index. The index focuses on the value segment of U.S. large-cap equities.
• VLUE, the iShares MSCI USA Value Factor ETF, is designed to track the total return performance of the MSCI USA Enhanced Value Index. The index focuses on the value segment of U.S. large-cap equities.

Of course, there are nuances to each of these approaches, but the overall focus is the same—predominantly large-cap stocks in the value style segment of the U.S. equity market.

Figure 1b: Standardized Performance

Just Value, or Value + Quality?

We recognize we don’t know what may or may not outperform going forward, but we do like the idea of owning the strongest businesses at reasonable prices as opposed to just the least expensive businesses overall. Inexpensive companies may represent opportunities, or they may represent value traps. DGRW, embedded in its process, seeks to measure the ROE and ROA of every underlying constituent, and includes only those with relatively higher figures. Even if, as we saw in figure 1a, DGRW screens into the U.S. large value segment of the Morningstar style box, the ROE and ROA metrics look markedly different.

Figure 2: The Intersection of Value and Quality

Conclusion: Why Are You Thinking about Valuation Risk?

We should all be honest about what leads us to think about valuation risk—we are concerned that the equity market may face a drawdown of some sort. In a drawdown, we know that anything can happen, but we prefer to have exposure to strong businesses with strong balance sheets and a proven capacity to generate earnings growth. While this guarantees nothing, it helps us to feel more prepared in case the unexpected happens.

Figure 3: Additional Information