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Value's Rough Patch Not a Concern for AQR's Ronen Israel

Risk-based and behavioral arguments support the theory of value delivering good long-term performance, says AQR's Ronen Israel.

Alex Bryan: We're at the 2017 Morningstar Investment Conference. Here today to talk about value investing with us, we have Ronen Israel, who is a principal at AQR. 

Ronen, value investing has paid off really well over the long term. It's a very intuitive investment philosophy, but it's hit a bit of a rough patch over the last 10 years. Over that stretch the Russell 3000 Value Index has underperformed its growth counterpart by more than 3 percentage points per year. Are you concerned that the value style is losing its efficacy?

Ronen Israel: Thank you, Alex. First of all great question, and it's great to be here. No, I'm not concerned. First of all, you mentioned the Russell indices. That's one particular measure of value. There are other measures of value that have done a little bit better than what you mentioned. But even take the information at its face value. It doesn't surprise me at all to go through a period of the last 10 years and to see underperformance. Value is a good strategy. It's a good long-term strategy. It's not a perfect strategy. It doesn't make money all the time. It is not a super high Sharpe ratio strategy. It is a strategy that can have long periods of underperformance, and that doesn't surprise me.

Take the equity market for example. The equity market is a good long-term source of return. I think most people would agree with that, but the equity market can go through long periods of underperformance. It doesn't surprise me to have the equity market down for 10 years much like it doesn't surprise me to have value underperform for 10 years. The reason for that is very simple. I think there are some key economic reasons why value delivers good long-term performance, and is a persistent source of return. Those economic theories have to do with either risk-based arguments, or behavioral arguments, but there are long-term empirical evidence, and strong economic intuition to support why value works. That's why I believe it's a good long-term strategy, and will continue to be.

Bryan: Let's explore those arguments a little bit further. So you mentioned risk, clearly some value stocks can be riskier than growth stocks; they're oftentimes facing a tough economic environment, or a tough business outlook. Investors are compensated for that risk, or should be, and that could be a reason why the value strategy might outperform. Could you talk a little bit more about that, and how that contrasts with the behavioral explanation?

Israel: Sure. I think you addressed it perfectly. The risk-based view of the world is that there is some compensation for bearing a risk that others don't want to bear. It's a transference of risk. So in that context you believe that value stocks have some type of systematic risk, and that they're exposed to that risk. As a value investor, you're exposed to that risk. Therefore, you need to be compensated for holding those stocks. I think there are good economic theories to support that argument for value investing as well as other types of factor investing.

There are also behavioral arguments for value. The behavioral arguments have to do with how investors oftentimes overextrapolate information, are overconfident. Overextrapolate for example the growth prospects of certain companies that can cause some companies to get overvalued, and some to get shunned, or undervalued.

Bryan: Are you concerned at all that those behavioral mispricings may become smaller as more investors try to take advantage of the value premium?

Israel: I think those behavioral concepts are so pervasive that it is hard to imagine enough capital moving into this system that can outweigh those very strong behavioral biases. These are biases that are ingrained in investors' behaviors, and it's hard to imagine those things going away anytime soon. 

Let's just take that for a moment and explore that a little bit. You take the historical results of value investing, which as you said have been very good. Let's assume for a moment they're not as good going forward. They're still a strong long-term source of return in value investing even if you believe they're not as good as they once were. So you have to really take a very strong view to believe that not only do these behavioral biases go away, or that there's enough capital in the system to outweigh them, but you have to take an even stronger view to say that it's enough to outweigh this really long-term strong source of return that we've observed.

Bryan: Now a lot of the value indexes that are out there simply just target stocks that represent the cheaper half of the market, and weight the holdings based on market capitalization, and there you tend to get some persistent industry biases.

Israel: Right.

Bryan: How important are these industry tilts for the value factor's efficacy?

Israel: Well I think when you look at value investing, value can be used for a stock-to-stock comparison. In other words, picking the cheap stocks versus the expensive stocks among their peers. It can be used to pick industries, or peers, peer groups, I mean. It can be used to choose the markets. It can be used to time markets. There are a lot of different ways that value investing can be used. I think what's important is when you look at the efficacy of value investing, the efficacy is going to be strongest when you can have better comparability, and more breadth, when you can build a more diversified portfolio. Where you find that is in stock-to-stock comparisons. So as a result, what you want to do is make sure that you allocate the amount of risk you're taking in value investing accordingly.

For example at AQR, we're going to put more weight on stock-to-stock comparisons. We're going to put more weight on choosing the cheap versus expensive stocks within their peer groups than we are on choosing industries, or choosing markets because there's more efficacy in that stock-to-stock comparison. For example, we might put 80% of our weight on stock-to-stock comparisons, and 20% of our weight, let's say, on industry comparisons.

Bryan: So most of the mileage comes from stock selection?

Israel: Absolutely, because that's where the efficacy is, and that's where you get better comparability. You're not picking up on long-term persistent differences for example in the growth rates of industries and things like that. You're truly getting the core pure value play of cheap versus expensive by focusing on the intended bets, and controlling the amount of risk that you're taking among them.

Bryan: Now a lot of this discussion on value focuses on value as a stand-alone factor, but at AQR I know that you have some strategies out there that try to combine value with other factors. Can you talk about the motivation for that approach?

Israel: Absolutely. Diversification is key. You want to diversify across many of these long-term sources of return, and we believe there are a few factors that deliver long-term sources of return. In particular, in the case of stocks, we think of value, we think of momentum, and we think of quality or defensive, as long-term sources of return. Importantly, each of those deliver long-term sources of return, but they're not perfect, again. They go through good times and bad times, but they tend to be lowly correlated with each other. In fact, value and momentum, as a great example, tend to be negatively correlated with each other. So by putting together a multifactor portfolio, integrating these factors into a single portfolio, what you're able to do is take advantage of the fact that they diversify one another, and you're able to capture a better, more consistent long-term source of return in factor investing. So diversification is a key element of investing in factors.

Bryan: Research Affiliates recently published some research suggesting that, you know, looking at the valuations of these factors can be important for trying to determine their expected returns going forward. Do you think you can use valuations to time your factor exposures, or is it better to have a long-term strategic allocation?

Israel: Yeah. First off I think it's better to have a long-term strategic allocation. It is hard enough as it is to identify these long-term sources of return. So once you identify things that you really believe in, like value, momentum, quality, and so forth, build a long-term strategic allocation to those ideas, and really try to stick with it over the long term. It is very difficult to time things, whether it's talking about timing markets, timing factors, timing anything is a very difficult proposition. We find very limited applicability to timing. We find very little evidence that timing adds value to a portfolio. Importantly, it takes away from that diversification a bit. So what we try to do is focus on a long-term strategic allocation. That's not to say that we completely rule out this possibility of timing. In fact, what we oftentimes say, a little tongue-in-cheek, is sin a little. Right, if you're going to sin, sin a little. So we're not saying don't do it at all, but it has to be a second-order effect to a long-term good, strategic allocation to these ideas.

You mentioned one way of timing, which is looking at relative valuation. As you mentioned, Research Affiliates has put out papers on this topic. The question that we think you need to ask when thinking about whether relative valuation adds to a portfolio, is whether it adds to a portfolio that already has value in it. So we're strong believers, and I think most investors have value in their portfolio. Once you have value in your portfolio, you're getting a lot of the benefit of the relative valuation comparisons among factors that they're talking about. We don't think it adds a lot more above and beyond that. So again I get back to diversification, long-term strategic allocation is the best way to go.

Bryan: Diversifying and staying invested for the long term.

Israel: Correct.

Bryan: Always good advice. Ronen, thank you for sharing your insights with us today.

Israel: Thank you Alex, always a pleasure to be here.

Bryan: For Morningstar, I'm Alex Bryan.