VFMF: Vanguard’s Multifactor ETF Is Just Value In Disguise (BATS:VFMF)

Investment Thesis

The Vanguard U.S. Multifactor ETF Shares (BATS:VFMF) is an actively managed ETF emphasizing momentum, quality, and value factors, but its performance since its February 2018 launch could be much better. As I concluded in April, an inconsequential volatility screen and poor quality metrics were to blame, and the purpose of this article is to evaluate if VFMF’s fundamentals have improved and if it accurately represents the momentum, quality, and value factors. In short, I will demonstrate that they don’t, and for that reason, I recommend shareholders exit the ETF.

VFMF: A Brief Overview

VFMF is based on a quantitative model that constructs a U.S. equity portfolio to achieve exposure to multiple factors. The approach, as described on VFMF’s fund page, is as follows:

1. The first screen removes the 20% most volatile names in each market cap segment and equally across all sectors from the benchmark Russell 3000.

2. Stocks are selected according to an equally weighted momentum, quality, and value ranking.

3. Momentum is calculated according to one-month, six-month, and one-year price returns.

4. Quality is based on return on equity, gross profitability, change in net operating assets, and leverage, except for financials, where return on equity and share issuance are the only inputs.

5. Value is based on a company’s book value to price ratio, forward earnings to price ratio, and operating cash flow to price ratio for non-financial companies.

VFMF launched on February 18, 2018, alongside three other dedicated factor funds, as follows:

1. Vanguard U.S. Momentum Factor ETF (VFMO).
2. Vanguard U.S. Quality Factor ETF (VFQY).
3. Vanguard U.S. Value Factor ETF (VFVA).

These ETFs have 0.13% expense ratios and are more successful based on higher AUM. They’re also more liquid in the secondary market, but VFMF is well-diversified, with only 10.35% of assets in its top ten holdings. These and other statistics are provided below.

VFMF Performance

It’s reasonable to believe VFMF’s historical returns fall somewhere between the returns of the three-factor ETFs. However, that has yet to be the case. Since March 2018, VFMF gained an annualized 7.60% compared to 9.01%, 8.99%, and 7.62% for VFMO, VFQY, and VFVA, respectively. Put differently, VFMF underperformed an equal-weighted portfolio of the three-factor ETFs by an annualized 0.94%.

VFMF best tracks VFVA, our first clue that the model could better balance these factors. Indeed, VFMF shared many features of a deep-value ETF in my previous two reviews, namely a high five-year beta and low valuation ratios. Notably, VFMF has badly lagged the iShares Russell 3000 ETF (IWV) by an annualized 2.88%. It also realized more volatility (standard deviation), which is typical of a deep-value portfolio.

VFMF Fundamentals

Seeking Alpha Quant Grades

My colleague, Retired Investor, noted in September how VFMF was the third-highest-rated mid-cap blend ETF. This data is available using Seeking Alpha’s ETF Screener, and currently, VFQY and VFMF rank #3 and #5, respectively.

VFMF scores well on Momentum, Expenses, and Dividends and lower on Risk and Liquidity, which I covered earlier. However, I want to add some important context. First, VFMF is not a mid-cap blend fund. Its weighted average market capitalization was $47 billion in April and $85 billion today. Furthermore, FactSet categorizes it as a Total Market Blend ETF, consistent with its selection universe (Russell 3000 Index). Second, I can derive how VFMF ranks on other factor grades available only to stocks by calculating weighted-average metrics for VFMF and 153 other Total Market Blend ETFs. The results are fascinating:

• Dividend Consistency Score: 6.02/10 (#142).
• Dividend Growth Score: 7.74/10 (#104).
• Dividend Safety Score: 7.09/10 (#133).
• Dividend Yield Score: 5.29/10 (#22).
• EPS Revision Score: 6.21/10 (#67).
• Growth Score: 6.21/10 (#98).
• Momentum Score: 7.18/10 (#85).
• Profit Score: 8.29/10 (#123).
• Value Score: 5.03/10 (#10).
• Quant Score: 7.37/10 (#14).
• Seeking Alpha Analyst Score: 7.27/10 (#18).
• Wall Street Analyst Score: 7.94/10 (#82).

These scores support my argument that VFMF is most like a value ETF and that its model does a poor job of balancing the momentum, quality, and value factors. Two examples are VFMF’s impressive dividend yield score, which ranks #22/154, and its net value score, which ranks #10/154. Growth and Profitability are below average at #98 and #123, while Momentum is average at #85. Given how VFMF’s Quant Score ranks #10, it’s logical to assume Seeking Alpha’s Quant System currently favors value stocks. It’s not unreasonable, given the dominance of Magnificent Seven stocks, but I want to highlight that VFMF’s strong value characteristics drive its top rating. In particular, VFMF’s profitability rating is troublesome and likely a key reason it has substantially underperformed IWV.

Fundamental Highlights

The following table provides a broad overview of VFMF’s fundamentals compared to VFMO, VFQY, VFVA, and IWV. This data supports the earlier conclusions, with relevant metrics including VFMF’s cheap 14.16x forward P/E and relatively weak 8.29/10 profit score.

Estimated earnings growth is sufficient, but historical and forward-looking sales metrics are below IWV. Also, consider VFMF’s high five-year beta, which is consistent across all VFMO, VFQY, and VFVA. I believe this best reflects the size segment the model aims for. VFMF’s $85 billion weighted average market cap is substantially below IWV, indicating limited exposure to mega-cap stocks, but to call it a mid-cap ETF is a stretch.

I want to highlight VFMF’s profitability and quality, which I view as a weakness. Margins generally look acceptable, but VFMF’s 12.90% free cash flow margin is about 3% less than IWV’s. The major contributors are Energy (9.44%) and Industrials (7.76%), which comprise 30% of the portfolio.

VFMF’s relatively high allocation to energy stocks also increases the chances that analyst estimates are unreliable, given the sector’s dependence on volatile oil prices. The table below shows the primary offset is a 14.80% underweighting in Technology. However, free cash flow margins are 20.77% in this sector, and the net profit score is solid at 9.16/10. Investors must balance these differences, as the reality is that lower valuation ratios are usually associated with lower quality. In my view, VFMF sacrifices too much.

Investment Recommendation

I have decided to downgrade my rating on VFMF to a “sell.” This rating change is based on how frequently VFMF leans on the value factor, leading me to believe it’s not a bug but a feature. VFMF’s long-term returns are similar to VFVA, and my analysis using Seeking Alpha Factor Grades confirms its impressive Quant Rating is mainly due to metrics like a 14.16x forward earnings valuation and a value score that ranks #10 out of 154 Total Market Blend ETFs. In short, VFMF is value-focused, and since that’s different from what shareholders signed up for, I recommend they exit the ETF. Thank you for reading, and I look forward to answering your questions in the comments section below.