Cheap Exposure to Large-Value Stocks

Value stocks tend to have less-attractive business prospects than their faster-growing counterparts, so they are not necessarily bargains. But they may offer compensation for their risk over the long term. They could also become undervalued if investors extrapolate past growth--or lack thereof--too far into the future. However, because most large-cap value stocks tend to be more widely owned and have more equity analyst coverage than their smaller counterparts, the market is less likely to significantly misprice them. The return advantage from tilting toward value stocks has historically been more pronounced among smaller-cap stocks, but larger-cap stocks tend to be less risky.

Because VTV covers half of the large-cap market, it includes some stocks with modest value characteristics. However, these holdings should help reduce volatility. The fund has less overlap with its growth counterpart

Low fees have helped the fund outperform its peers and continue to give it an edge. Over the trailing 10 years through December 2015, it outpaced the average surviving fund in the category by 1.2 percentage points annually. Adding to the fund's cost advantage, its benchmark applies a wide buffer zone to limit turnover, which should help mitigate transaction costs.

Fundamental View Value stocks have a good long-term record in most markets studied. From December 1978 through January 2016, the Russell 1000 Value Index (which offers similar exposure to this fund) outpaced the Russell 1000 Growth Index by 1 percentage point annualized. But this outperformance has not been consistent. Over the trailing 10 years through January 2016, the Russell 1000 Value Index lagged its growth counterpart by 2.5 percentage points annualized. Yet there is reason to believe that value stocks will offer a modest return edge over the long term.

Investors may demand higher expected returns to own value stocks, which have less-attractive business prospects than their growth counterparts and could be riskier. Value stocks tend to be less profitable, grow more slowly, and are less likely to enjoy sustainable competitive advantages than growth stocks. Over the trailing 12 months through December 2015, VTV's holdings generated a lower return on invested capital (9.9%) than those in Vanguard Growth ETF (15.1%). This is probably related to the fact that a smaller portion of the fund's assets is invested in stocks with wide Morningstar Economic Moat Ratings, Morningstar's assessment that a firm enjoys a sustainable competitive advantage, than its growth counterpart.

Despite these characteristics, value stocks have historically offered better risk-adjusted returns than their growth counterparts. This lends some credence to the view that investors may extrapolate past growth too far into the future, which can create systematic mispricing that may contribute to value stocks' return advantage. But even if these stocks are undervalued, they can remain out of favor for years. This means that low valuations do not translate into easy profits, as the performance of these stocks during the past decade demonstrates. There is also a risk that the value effect may be smaller in the future because more investors are aware of it and trying to take advantage of it.

VTV's broad reach and market-cap-weighting approach limit its exposure to the cheapest stocks, which may also limit its return advantage. Market-cap weighting skews the portfolio toward the largest value stocks, which are not necessarily the cheapest. However, this approach helps foster low turnover and reduce risk. Like most of its peers in the large-value category, the fund skews toward the financial services, energy, and utilities industries. However, it has greater exposure to the healthcare and financial-services sectors than the category average and less exposure to consumer cyclical stocks.

Lower expected earnings growth may justify VTV's lower valuation relative to its growth counterpart. Over the trailing 10 years through December 2015, the fund was trading at an average price/forward earnings discount of 4.5. When the valuation gap between this fund and Vanguard Growth ETF widens, the value fund may have a better chance to outperform.

Portfolio Construction The fund employs full replication to track the market-cap-weighted CRSP U.S. Large Cap Value Index. CRSP defines large-cap stocks as those representing the largest 85th percentile of the U.S. stock market. It uses several metrics to assign composite value and growth scores to each stock. The growth metrics include projected short- and long-term earnings per share growth, three-year historical earnings and sales per share growth, current investment/assets, and return on assets. CRSP evaluates value on book/price, forward and trailing earnings/price, dividend yield, and sales/price. It fully allocates stocks with the strongest value characteristics to the value index until it represents half the assets in the large-cap market.

CRSP keeps 100% of each stock in its respective style index until it passes through a buffer zone. At that point, CRSP moves only 50% of the stock from one style index to the other. If the stock stays on the opposite side of the buffer zone at the following quarterly review, CRSP will transfer the remaining half. This approach mitigates turnover where it does not significantly affect the fund's style characteristics.

Fees Vanguard charges a rock-bottom 0.09% expense ratio for this offering, making it one of the cheapest funds in the category. Vanguard engages in securities lending, the practice of lending out the fund's underlying holdings in exchange for a fee. This ancillary revenue helps offset some of the fund's expenses. During the past year, the fund lagged its benchmark by 3 basis points, less than the amount of its expense ratio.

Alternatives

Investors concerned about unintended sector bets that traditional value funds could introduce might consider

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