URTH: Global Equities Appear Undervalued In February 2024 (NYSEARCA:URTH)

Introduction

iShares MSCI World ETF (NYSEARCA:URTH) is an exchange-traded fund with a mandate to provide investors with global equity coverage across a “broad range of developed market companies”, at a reasonable cost of 0.24% (reported expense ratio). The fund currently has a substantial asset base, with an AUM of $3.13 billion as of February 14, 2024, spread across 1,481 different holdings. According to YCharts, net fund flows have been slightly contractionary over the past year, at negative $57.37 million; however, this is relatively stable considering the fund’s AUM size.

Much time has passed since I last covered URTH in February 2022, at which point I was actually inopportunely bullish on the fund’s valuation (2022 was, of course, a difficult year for equities as it turned out). However, the fund did bounce back from its 2022 lows, and is currently trading higher than its price at my last article’s date. It is worth revisiting with a more complete valuation method in February 2024, in addition to the key details such as geographical and sector exposures, especially since URTH (being a large, global fund) is quite a good proxy for the valuations of equity markets in general.

Portfolio Construction Process

URTH’s portfolio is built to track the MSCI World Index, “which captures large and mid-cap representation across 23 Developed Markets countries.” The index had 1,480 constituents per a recent factsheet as of 31 January 2024, whereas “the index covers approximately 85% of the free float-adjusted market capitalization in each country.” The goal is to track rather than beat the index’s performance.

Per the prospectus also, “The Fund generally will invest at least 80% of its assets in the component securities of its Underlying Index and in investments that have economic characteristics that are substantially identical to the component securities of its Underlying Index”, and “d may invest up to 20% of its assets in certain futures, options and swap contracts, cash and cash equivalents, including shares of money market funds advised by BFA or its affiliates, as well as in securities not S-2 included in the Underlying Index, but which BFA believes will help the Fund track the Underlying Index.”

There is some degree of “risk” to this sort of process, as smaller funds may have less ‘tracking error’ risk given lower AUM and breadth. Nevertheless, as a fund grows larger with a larger (more diluted, if you like) investment mandate, the risk of tracking error can often fall owing to the more “beta-like” diversified nature of the fund. Nevertheless, per Track Insight, we can see URTH’s running tracking error is consistently within 50 basis points.

Fund literature historically referenced quarterly rebalancings, however there are no explicit mentions of the rebalancing process for URTH in any of its presently available literature. It is likely that iShares, with its deep access to liquidity with Authorised Participants, etc., as well as through the use of derivatives, is able to actively rebalance URTH’s portfolio without “scheduled” rebalancings, which may even be an advantage in place of otherwise seemingly arbitrary scheduled rebalancings. Arbitrary dates for rebalancings could create unnecessary market risk given the size of the fund, also attracting arbitrage traders.

Geographical Exposures

Per iShares, URTH’s key geographical exposures are as follows, revealing a heavy weight in favor of the United States (at 70.88% of the fund), followed by Japan (6.03%) and the United Kingdom (3.76%).

The fund is largely focused on U.S. equities, but that is owing to the size and depth of U.S. equity markets. URTH’s ability to rebalance across geographies and also enjoy underlying FX hedges on the circa 30% non-U.S. balance is a positive quality.

Sector Exposures

Morningstar provides us with the chart below, which presents URTH’s key sector exposures as including Technology (at 25.49% of the fund, as of February 9, 2024), followed by Financial Services (14.31%) and Healthcare (12.23%); respectively, these three sectors are in the different categories of Economically Sensitive, Cyclical, and Defensive. Clearly, there is no particular bias here, although the slight technology bias will be as a result of URTH’s U.S. bias by weight (U.S. equity markets themselves being biased toward today’s mega-cap tech stocks).

The high level of geographical and sector diversification makes URTH a low-beta fund. Yahoo! Finance, for example, provide a five-year monthly estimate of 1.04x. I calculate URTH’s beta on a three-year monthly basis versus the S&P 500 U.S. equity index of 0.98x, with practically the same figure for “upside beta” and “downside beta”. In other words, URTH behaves very similarly to the S&P 500 U.S. equity index, which is unsurprising.

We can also see the reflection of some of the S&P 500’s heavier weights in URTH’s top 10 holdings, however the concentration is relatively moderate, with the top 10 representing 21.60% of the fund as of recent. You can see the top holdings including Apple Inc (AAPL), Microsoft Corp (MSFT) and Nvidia Corp (NVDA) at a collective 12.03%, but as you move down the table, even the eighth, ninth and tenth largest holdings each represented less than 1% of the fund. URTH clearly has some U.S. tech-specific risk, but this is by virtue of these stocks’ large weights in the U.S. equity markets by market cap. URTH allocates pursuant to its benchmark index’s traditional market-cap-weighted method.

URTH can, however, under-perform over longer periods, or even shorter ones. For example, over the past year, URTH rose 16.83%, whereas the S&P 500 rose 21.24%. Over five years, the figures are 59.18% and 81.17%, and URTH did not make up for this in dividends. SPDR S&P 500 ETF Trust (SPY) is a popular S&P 500 tracker; SPY generated a five-year total return of 14.21% per annum, against URTH’s total return of 11.53%. Having said this, past results do not dictate future performance. I will now value URTH objectively using the present facts.

Basic Valuation

It is worthwhile making as few assumptions as possible, and not tailoring one’s valuation to any particular narrative, at least not initially. Bear in mind we typically would want to see an equity risk premium of circa 3.2-5.5%, plus a risk-free rate component and any other country-specific risk premium (in this case weighted by the various geographical exposures at play) to gauge fair value for funds like URTH.

URTH’s benchmark index is the MSCI World Index, whose most recent factsheet provides a starting point: a trailing dividend yield of 1.90%, current and forward price/earnings ratios of 21.22x and 17.67x, respectively, and a price/book value of 3.14x (all figures as of January 31, 2024). Meanwhile, Morningstar provides an analyst consensus estimate figure for three- to five-year earnings growth (for URTH’s portfolio) of 10.39%. We can plug this into the model, although I will arbitrarily under-cut this a little, for 9% earnings growth over a three-year time horizon. I think this is reasonable in consideration of the current return on equity of the portfolio, and assuming that this matures gradually over the next few years to closer to 15% (although this may prove to be conservative).

Using the above figures from MSCI, the implied forward return on equity of the portfolio is currently 17.77%, with a distribution rate of earnings into dividends of 40%, and an implied forecast one-year earnings growth (from MSCI’s index factsheet) of 20.09%. We will also assume no buybacks going forward. Holding the forward price/earnings ratio constant, and using the 9% shorter-term earnings growth average assumption, my model indicates a potential IRR of at least 11.5%.

This also factors in the weighted average risk-free rate using 10-year yield data, plus country risk premium estimates from Professor Damodaran. The underlying equity risk premium is 7.87%. If I were to increase the earnings growth rate to more closely match Morningstar’s 10.39% figure, the IRR and ERP expand to 12.15% and 8.45%, respectively.

At the moment, the U.S. 10-year yield is 4.24%. Even with an equity risk premium of 4.5%, this would lend to an IRR of 8.74%; in other words, U.S. equity investors should probably be demanding this figure, or something in the range of about 7.44% to 9.74% (ERP: 3.2-5.5%). Even on the high end, URTH seems like it has room to move higher. If the underlying ERP was only 5.5%, based on the same risk-free rate and country risk premium (both weighted), the IRR “should” be something similar to 9.2%. That implies that URTH should move higher by about 25% on valuation alone.

Therefore, at this present juncture I believe that URTH is undervalued. Since URTH is effectively “equity beta” given the high level of diversification, I would take this to mean that broader equity markets are likely undervalued. That does not necessarily extend to all areas of the equity market globally, of course, but it does potentially bode well for higher beta and market sensitive funds.

Downside risks are likely to be limited more so to market risk and risk sentiment. Over a long time horizon, the current implied IRR potential is high, thus long-term shareholders should be comfortable holding URTH at present prices. An alternative risk would be an economic ‘black swan’ or otherwise cyclical but surprising downturn in which near-term earnings projections are subsequently punctured. However, current macroeconomic indicators would not lend to this, with positive GDP growth, moderating inflation, and relatively low unemployment levels.