Why New ‘Intrinsic Value’ ETF Had To Be Passive

Diamond Hill is a newcomer to the ETF space. The Columbus, Ohio-based money management firm is known for a roster of strategies that focus on intrinsic value. But perhaps just as important, Diamond Hill is an avid believer in active management, which is why it’s so interesting that the firm’s first-ever ETF launched in May is a passive fund: the Diamond Hill Valuation-Weighted 500 ETF (DHVW).

Ric Dillon, CEO of Diamond Hill—which manages $16 billion in assets today—told us why they chose to go passive in an ETF wrapper, and what DHVW should deliver thanks to its focus on intrinsic value of large-cap companies.

ETF.com: All of your strategies center on the concept of intrinsic value. Perhaps the most commonly used metric out there is price-to-book, but you determine value based on estimates. How is that a more reliable way of determining value?

Ric Dillon: That's a critical distinction, both for all of our strategies as well as for this ETF. There are ETFs that try to isolate factors like price-to-book and so forth, but those are more backward-looking. The intrinsic value concept that we use is forward-looking and, as such, the estimates are important. The key distinction here is that we have created a rules-based strategy that’s forward-looking.

There are two particular features to our discounted cash-flow methodology that are different. One is that we use a mean-reversion concept in capitalization rates—meaning that over a five-year period, a P/E ratio will move down toward the average if it's above average, or vice versa. That mean reversion is not only what economic theory suggests should happen, but it's also what's been found empirically to happen.

The second is that, almost always, cash-flow methodologies ignore the balance sheet. We’ve pulled the balance sheet into this calculation through the use of the tangible book value. That, plus mean reversion, are the two things that make our intrinsic value approach different from other intrinsic value or discounted cash-flow methodologies that are forward-looking. And of course, all of those are different from the backward-looking price-to-earnings, price-to-book kinds of ideas.

The idea of "intrinsic value" is that all companies have a value that is independent of the stock price. The stock price may or may not be a good approximation of that value. You, as an investor, should be trying to buy stocks at a discount to what you estimate their intrinsic value is, or selling them if they’re above intrinsic value.

ETF.com: Is that what your ETF does, essentially?

Dillon: On this ETF, we're underweighting those stocks that tend to be overvalued with this methodology, and we're overweighting those that tend to be undervalued.

ETF.com: Should investors expect to see a significant dispersion between the intrinsic value and the stock price of a company?

Dillon: Oh, yes. When you think about it, at a very high level, all companies are a function purely of cash flows, however they may be derived in the future. As you get further away from the present, those cash flows are increasingly uncertain.

If we knew with certainty what those cash flows would be, we would be able to arrive at the intrinsic value. Instead, we're estimating the future, so we're always estimating intrinsic value. The stocks may or may not approximate that. Stock price and the estimate of intrinsic value technically are independent of each other. Whether there's a small divergence or a large divergence is just a function of facts and circumstances.

ETF.com: What’s the pitch of this ETF to investors? Why should they own it?

Dillon: If the first generation of passive investing was the market-cap approach, consistent with the efficient market hypothesis, this is a second-generation approach wherein—by applying this intrinsic value methodology—you should arrive at better returns. You are overweighting those stocks that through this methodology appear undervalued, and underweighting those stocks using this methodology to appear overvalued.

Compared with first-generation ETFs, we hope to provide returns 50 to 100 basis points annualized higher. We hope people who are thinking about using SPDR S&P 500 (SPY | A-99) would instead choose to use this because they expect to get a higher return with a very similar risk profile.

To people who are looking at other value-based approaches, whether it's a WisdomTree or a Research Affiliates-type of approach who use factor models in a way that gets to value through historic-looking models, we're saying our alternative is forward-looking, and it should provide a better result and a different risk profile. Our goal is to demonstrate that over the next five years.

ETF.com: You’re saying investors can replace a core allocation like SPY with this ETF?

Dillon: Yes. Absolutely. Clearly, people have sliced these things in different ways and tried to capture the broad index or the value component or the growth component of those indexes. But our thought is that this approach should provide better returns and a comparable, if not better, risk profile than SPY.

ETF.com: Could this intrinsic value concept be applied to smaller-cap names as well?

Dillon: It would be difficult to apply it to a small-cap index where you wouldn't have consensus estimates. Perhaps we would do another one at some point with, say, midcap stocks or large-cap international stocks. But by needing the consensus estimates, that would limit us in terms of what companies we can look at.

Consider that, for instance, our own company is in the Russell 2000; we're probably ranked about company No. 1,200. We're at $675 million market cap. And nobody follows us. There's no consensus estimate on us. That's why you can't really do it for the small-cap names.

ETF.com: What's the downside to this forward-looking approach?

Dillon: Over the short term, those that use the historic-based factor model approach will have very different return profiles than ours, whereas, if you look at SPY, our return profile will be very similar to that on a monthly basis. That doesn’t make them more or less risky, just makes them different.

The criticism of forward-looking approaches, of course, is that if the estimates are too high, you're going to have intrinsic values estimated to be too high. That's what we see in the market all the time, where a company has a disappointing result or forecast and the stock goes down. That's the problem with forward-looking approaches.

ETF.com: As a company, you are known for active management. Why did you choose to go passive on your first ETF instead?

Dillon: The challenge with active strategies in ETFs is transparency. Because we have active strategies in mutual fund form, if we had it under the current regulations with ETFs, we'd have to disclose holdings, and people would be able to see and front-run the mutual funds, the separate accounts, with what we were doing in the ETF.

Until those regulations change—and I know Eaton Vance, of course, is trying to address this issue in a unique way—we wouldn't anticipate having any of our active strategies in an ETF form.

ETF.com: Diamond Hill has been in the money management business—mostly with mutual funds—for 15 years. Why launch an ETF now?

Dillon: This is a near-term benefit to us. To the degree this ETF demonstrates efficacy, it reflects well on our active strategies, because our active strategies use this intrinsic value model.

The second benefit is that there's a whole set of investors who prefer passive strategies, and they don't want to talk to us about our active strategies. We understand that. So, by being able to come to them with a passive strategy, we now have opened up a market that, prior to this launch, was not open to us.

We know that the ETF market is large and growing, but our market share, which is zero, could be considerable if we're able to demonstrate that 50 to 100 basis points in extra annualized returns. Long term, we think it'll be a very profitable strategy.

I guess another additional benefit is that it's conceivable ETF regulations will change. By having a strategy now in the ETF world, we get to learn about the ETF market, establish a name, and be ready to launch active ETFs if those regulations were to change.