Wed, 3 May 2017
Research Affiliates' John West says indexing based on fundamental factors, and not stock price, can help capture the value factor without buying the priciest securities.
Alex Bryan: For Morningstar, I'm Alex Bryan. We're here on the sidelines of the 2017 Morningstar Investment Conference. Here today to talk with me about value investing is John West. He is the head of client strategies over at Research Affiliates.
Value investing has become increasingly popular among index investors over the past decade, but these strategies come in many different flavors. So, John, Research Affiliates takes a little bit different approach to value investing. It offers several strategies that weight their holdings based on fundamental measures of size, like book value and sales, rather than market capitalization. What's the motivation for this approach and can you talk about how it does give you a bit of a value tilt to it?
John West: Sure. So, the motivation really came out of the tech bubble where we just observed that weighting securities by price, and they become massively overpriced, cap weighting forces you to go along for the ride. And when that reversal happens, when those overpriced securities start to underperform, you just have a maximum weight to them. And so, in our minds, that created a return drag. So, we really wanted to fix that return drag but meanwhile keep many of the positive attributes of index investing. And those positive attributes are massive capacity, economic representation, low costs, low turnover. And so, we find that let's substitute a proxy for size, not being market capitalization, but these fundamental weights.
Now, does that give you a value exposure? Of course it does, because you are saying how big is this company today? Where market cap says is not how big is the company today, but how big is it going to be in the future?
Bryan: So, what's the advantage of taking this type of fundamental weighting approach over just a traditional value index fund where you're just targeting, let's say, the cheaper half of the market and then weighting the holdings by market capitalization?
West: So, what that fundamental anchor does, that fundamental weight, you start with that and then every year you rebalance back to that, and that's really the critical thing that that fundamental weight does for you. It forces you to rebalance. A market-cap-weighted value portfolio just takes half of the universe by market cap, the cheapest of those, and weights them by market cap. So, if something becomes cheaper or richer over time, you just hold the same amount, you're just doing it within value universe. Fundamental index by contrast, as something becomes more and more expensive, it continually rebalances against that. So, it takes a larger value tilt. We find when you get really big extreme bets between value and growth, the fundamental index widens its value exposure and typically does a fairly good job of adding value through that dynamic value tilt.
Bryan: Right. So, it's doubling down on names as they become cheaper?
West: Absolutely. And we find that on a return basis, that's the intuition. So, what are the results? The results are about 1.5% per year over a market-cap-weighted value portfolio. In our back-testing, interestingly, since we launched these strategies in 2005, we again see about 1.5% sort of being the central tendency of a fundamental index despite actually owning a lot of growth stocks, just re-weighting them back to their economic scale, but about 1.5% return premium over cap-weighted value.
Bryan: Now, a few years ago, Research Affiliates published some research that suggested that a lot of the value premium comes from this rebalancing effect, basically selling stocks as they move from the value bucket into the growth bucket and buying names as they become cheaper as they fall out of that growth bucket. Can you explain why this is and what the practical implications for investors might be?
West: Sure. So, if we think about where do equity returns come from, they come from your dividend yield, plus changes in valuation, plus growth in dividends. And you can look at that for virtually any equity market, you can look at Research Affiliates' asset allocation site, that's the typical return decomposition. When we apply that to growth stocks, you typically find a lower yield, right? We expect them to grow more in the future. So, they typically have a lower yield.
Valuations are sort of cyclical. They move around. But what about dividend growth? Most people say, well, growth stocks are actually going to grow their dividends faster. And that's true for growth stocks. Now, for a growth portfolio where every year you are figuring out, well, is this a growth stock or did it fall enough in price to go into the value portfolio? We actually find the growth portfolio actually has lower dividend growth than the value portfolio because every year, what's happening? Well, the growth stocks that have fallen off in price fall into the value bucket. They've fallen enough in price so they actually give you a pretty good yield. So, the value portfolio is picking up yield through that annual exchange. Meanwhile, the value stocks that have risen enough in price and therefore have lower yields are getting pushed to the growth side. So, we actually find back to that return decomposition value tends to give you on average a higher yield, but you also get greater dividend growth.
Bryan: Because of that rebalancing effect?
West: Because of the rebalancing effect. And so, as a value investor over a long time period, not every five years or even every 10 years, you tend to have your cake and eat it, too. You get higher dividend yield and you get more dividend growth strictly because of the rebalancing process.
Bryan: Research Affiliates more recently published a series of papers arguing that you could use valuations not only to select stocks of higher potential returns but also to identify factors or smart beta type strategies that are likely to give you better performance going forward. Can you explain the motivation for that and what factors currently look cheap to you?
West: Yeah. Sure. So, the motivation behind it is, we've got a lot of people at this conference talking about, look at how great factor returns are. Now, if those factor returns have come from some sort of structural return, that's great. If they've become solely or predominantly because of rising valuations--for example, low-volatility stocks are becoming more expensive than they were 10 or 15 years ago--that's a dangerous thing to extrapolate moving forward. So, we want to say, what would the return be if you didn't have those rising valuations? Or what would the return be if those valuations don't rise and actually start to fall? So, let's set really proper expectations.
And when we do that, and we publish these on our website at Research Affiliates, we find today that value and quality in the U.S. are fairly reasonably priced. We think those will give you pretty similar to your historical level of long-term returns. Low volatility is actually fairly expensive. When we move into non-U.S. markets, we find value is incredibly cheap and just about everything else is expensive. So, we'd tell you, tamp down your return expectations on some of these strategies that today are trading very, very expensive.
Bryan: All right. So, don't anchor to the past performance. Look at valuations that tell you more about where things are heading.
West: The same thing that a lot of people are saying at this conference. Don't chase performance.
Bryan: All right. Great. Thanks for sharing your insights with us today.
West: My pleasure.
Bryan: For Morningstar, I'm Alex Bryan.