Fund in Focus: iShares U.S. Fundamental Index ETF

Fund in Focus: iShares U.S. Fundamental Index ETF

Built to withstand volatility

Looking at the recent performance of the fundamentally-built iShares U.S. Fundamental Index ETF (NEO: CLU), it’s easy to dismiss it compared with other lower-cost, cap-weighted funds. But I don’t believe that the recent performance of the cap-weighted ETFs tells the whole story.

A significant portion of the cap-weighted return has been driven by a few mega-cap tech stocks like Facebook, Amazon, Apple, Netflix, and Google-parent Alphabet, which combined make up roughly 15% of the S&P 500 Composite Index. But along with soaring share prices, their valuation levels have also climbed.

For example, at the end of June Inc. (NASDAQ: AMZN) was trading at more than 80 times forward earnings, while Netflix Inc. (NASDAQ: NFLX) traded at 133 times. Clearly these levels are not sustainable over the long-term, and a correction will need to occur at some point. Moreover, the tech rally has pulled valuation levels of the broader U.S. equity market to the upper end of the historic averages, making the entire cap-weighted index ripe for a potential selloff.

One way to help insulate against this risk is to use an ETF that is built using a set of rules that moves beyond the size of a company, and this iShares offering may be just the ticket. The fund scores the U.S. equity universe on several fundamental metrics including dividends, free cash flow, sales, and book value. It holds about 1,000 positions, and the weight of each is determined based on its relative score. Those that score better comprise a larger portion of the portfolio than those that score poorly.

The result is a portfolio that is designed to have a fundamental makeup that is better than the index, offering attractive valuation, yield, and growth rates. While the valuation levels are significantly more attractive than the cap-weighted indices, the growth profile is a little less favourable, given the underweight positioning of some of the high fliers.

Although a cap-weighted ETF for U.S. equities has historically been an excellent choice, I believe that if we hit a period of extended volatility, the fundamentally constructed ETF will offer a more attractive risk-return profile. I expect this ETF will also outperform when the market focus returns to valuation and quality.

A concern with CLU compared with a cap-weighted ETF is its cost, with an MER of 0.72%, compared with 0.11% for XSP. While I believe this higher cost can be offset in a down market, it does act as a headwind in a flat or rising market environment.

iShares U.S. Fundamental Index ETF (NEO: CLU)
Fund company: BlackRock Asset Management
Fund type: Exchange-traded fund
Fund category: U.S. Equity
Trading symbol: AQN: CLU
FundGrade Rating: C (May)
Style: Large-Cap Value
Risk level: Medium
RRSP/RRIF Suitability: Good
Manager: BlackRock Asset Management
MER: 0.72%

Dave Paterson, CFA, is a money manager and an expert on investment fund research and due diligence on a variety of investment products.

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