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exchange-traded funds

A worker operates a smelter near Copper Cliff, Ont. Some investors are finding value in sectors that have underperformed the overall market, such as base metals, energy and industrials.Gino Donato/The Globe and Mail

Despite the stock market's recent volatility, most investors have been very pleased with its strong performance over the past year or so. But the stellar market performance also has a downside, especially for investors who are strict about only buying stocks that haven't climbed to an overinflated price.

The challenge is: How do you find value in this market environment?

One answer may be to look for exchange-traded funds (ETFs) that offer a way to buy into stocks that have been left out of this record-setting market rally.

"Generally speaking, stocks are certainly more expensive than they were one or two years ago," says Lindsay Patrick, director of Global ETF Strategy at RBC Dominion Securities Inc. in Toronto.

She notes the combined ratios of stock price to forecasted profits (forward P/E) for all major stock indices have climbed well above historical averages, though they are still below a historic high. However, she sees room for further advances, as earnings estimates rise because of a combination of a stronger global economy driving improvement in revenue, lower corporate tax rates and added share buybacks.

Ms. Patrick says the benefits of owning ETFs apply for value investing, just like they do for any other market focus you may be looking for. Those benefits include liquidity, low expense ratios and diversification beyond individual stock-picking.

"ETFs can also offer direct exposure to certain sectors or geographic regions that investors may feel are undervalued," she says. She notes investors need to be aware of the sector exposures for value funds. Currently value funds tend to have more of an exposure to cyclical sectors such as energy and mining, as well as financials.

As far as specific recommendations go, Ms. Patrick has three picks that focus on three separate geographies. For Canadian exposure, she recommends the BMO MSCI Canada Value ETF (ZVC). This is a new ETF, launched in the fall of 2017. The fund has one of the lowest management expense ratios (MERs) of the Canadian value ETFs, at just 0.40 per cent. Stocks are selected using three variables: book value to share price, forward price to earnings ratio, and dividend yield.

"It's well diversified into 49 different stocks and across a variety of industries," Ms. Patrick says. "The sector exposure is close to the Canadian market in general so investors are not taking large sector bets that are dramatically different from the underlying Canadian market."

For global exposure, Ms. Patrick favours the iShares MSCI EAFE Value ETF (EFV). This fund is based on value stocks in Europe, Australia and the Far East. It has more than US$6-billion of underlying assets and has been trading for more than 12 years.

"Canadian investors generally are overexposed to U.S. and Canadian stocks, so this ETF provides international exposure with a value overlay in one ticker," she says. The fund holds the stocks of almost 500 large-cap, blue-chip international companies with the largest exposure to Japan, Britain, France and Germany.

Ms. Patrick's selection for U.S. exposure is the Vanguard Value ETF (VTV). This is a well-established ETF that launched in 2004 and has almost US$38-billion in assets under management. The fund invests in 330 large-cap U.S. stocks based on five stock price-based valuation measures. The MER is very low, at just 0.06 per cent. "The largest sector exposure is U.S. banks – a sector we are positive on given the opportunity for earnings updates, higher dividends and tax reform," says Ms. Patrick.

While the market's strong performance has made value more scarce, some investment managers don't seem to be having difficulty putting money to work. "Is it tough to find value right now? No is the short answer," says Robert (Hap) Sneddon, president and portfolio manager at CastleMoore Inc. in Mississauga.

He says there is value within individual sectors – namely, stocks that have lagged the performance of that group. As well, he notes there is value in sectors that have underperformed the overall market, such as energy, base metals and industrials.

Mr. Sneddon says there are at least two ways ETFs can be a good way to value-invest. The first is as an efficient way to take advantage of undervaluation in a specific sector of the market. He notes that an ETF ensures you get the general move and have safety in numbers as the sector fluctuates.

"Buying the complete sector in one shot can be better than building your own basket," he says. "It can help prevent you getting burned by buying the wrong stock."

The second situation is if an investor feels value will be better than momentum or growth styles over a specific time period. Then an ETF can be bought that tracks a value index such as the U.S. Large Cap Value Index (CRSP).

For specific value ETF suggestions, just like Ms. Patrick, Mr. Sneddon recommends the Vanguard Value Index Fund (VTV). He likes its diversification, citing its investment in energy, financials, consumer staples and technology.

Mr. Sneddon's second recommendation is the iShares S&P/TSX Global Base Metals Index ETF (XBM). He says that with the trend of global economic growth and central bank interest rate increases, industrial/base metals offer one of the best upsides in the next six months.

He points to increased infrastructure activity, dwindling commodity stockpiles and few new mine projects as tailwinds for the sector in 2018.

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