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3 Shades of Value

Not all value strategies are created equal.

Value investing has long been associated with excess rates of return. Generally speaking, a value-oriented approach involves buying stocks that are cheap according to some measure of intrinsic value in hopes that they will one day appreciate to their fair value. But that day may be a long time in coming--if it ever comes at all. Patience is a requirement, and the past decade has tested the strongest advocates of value investing. For the 10-year period through June 2018, the Russell 1000 Value Index underperformed the broader Russell 1000 by 1.7 percentage points annually. Adding insult to injury, it was also more volatile and suffered deeper drawdowns during the depths of the global financial crisis.

By measure of the same Russell Indexes, value continued to have a difficult time as it emerged from its postcrisis nadir. From March 2009 through June 2018, the Russell 1000 again outpaced the Russell 1000 Value Index, in this instance by almost 1.6 percentage points annually. However, drawing the conclusion that all value strategies underperformed during this period would be shortsighted. Not all value strategies are created equal.

Large-cap value funds are plentiful in the United States. Here, I’ll look more closely at a select subset of index-tracking funds within the large-value Morningstar Category. My sample is dominated by exchange-traded funds with at least 10 years of returns. I’ve also included

A quick review of this group shows that some have indeed outperformed the broader U.S. stock market in the postrecession bull run. From March 2009 through June 2018, five of the 18 considered funds beat the

To investigate this further, I ran a four-factor regression using data from Ken French's data library [1]. The factors considered in this study were: market (beta), size (small-minus-big, or SMB), value (high-minus-low, or HML), and profitability (robust-minus-weak, or RMW). The outcome of this analysis showed that funds generally landed in three different buckets. Here, I'll define them as deep value, value + profitability, and mild value.

Deep Value Funds that I've classified as deep value were those with the heaviest loadings on high-minus-low. In other words, they favor the cheapest of the cheap stocks. The regression results in Exhibit 1 show that these funds have offered the purest exposure to value, with HML coefficients of 0.3 or larger. Each of the three uses different selection and weighting methodologies, but there are some similarities. All tend to overweight the smallest and cheapest of the companies in their respective selection universes. These weights are based on a number of fundamental metrics such as price/book, price/earnings, and price/sales.

Rebalancing into ultra-cheap shares at the market’s lowest point helped these funds outperform VTI in 2009 as the recovery got underway. DFA U.S. Large Cap Value,

The excess returns generated by these strategies didn’t come easy. These funds had some of the deepest drawdowns during the market downturn in early 2009. RPV was down from its nearby peak as much as 70% in February 2009 compared with 51% for VTI. As the recovery progressed, these deep value funds continued to be among the most volatile in the large-value category. Their standard deviations and market exposures (market betas) were among the highest of any of the funds included in this study.

Value + Profitability The other value-oriented group with strong postcrisis performance featured funds with exposure to two investment styles. This bunch was less exposed to value than the deep value set and tilted toward the profitability factor (RMW). Profitability is sometimes used as a proxy for a firm's quality. All the funds I've assigned to this group had a statistically significant loading on both value and profitability factors.

The overlap between quality and value stems from how these funds select their holdings. A number of these funds track indexes that either screen or weight their holdings by dividend payments or yields. Dividend strategies can cue off measures that may also be indicators of value (dividend yield) and/or profitability (dividend stability or growth). All things being equal, if and when a company is profitable, it may increase the dividends that it pays to shareholders. In this instance, a higher dividend payout may signal management’s confidence regarding future profitability. On the other hand, dividend yields can increase when a stock’s price declines. This could result from a slump in a firm’s prospects. Thus, a strategy that emphasizes dividends may buy companies that are increasing dividend payments (profitability), those that have experienced recent slump (value), or some combination of the two.

The major benefit of having a portfolio that is exposed to both value and profitability is that these two strategies can diversify each other. In his paper "The Other Side of Value: The Gross Profitability Premium," [2] Robert Novy-Marx demonstrated that value and profitability strategies are negatively correlated. Value strategies purchase stocks of companies that are on the ropes, while strategies based on measures of profitability tend to invest in firms with rosier prospects. Therefore, when one strategy is doing poorly, the other is likely performing well.

The inclusion of profitable firms helped some of these funds outperform the broader market between March 2009 and June 2018. Two outperformed VTI, while another two lagged by less than one fourth of a percentage point annually. Monetary policy in the postrecession period provides an additional explanation for these strong returns. In late 2008, the Federal Reserve began cutting interest rates, intending to jump-start economic growth and promote investment. Yields on bonds consequently dropped, leaving investors looking for alternative sources of income. The increased demand for higher-yielding investments was a likely contributor to the strong returns that dividend-paying stocks generated.

The marriage of value and profitability also resulted in a smoother ride relative to the deep value funds. The emphasis on profitability, or quality, produced portfolios with less market risk (market beta). The market coefficient for this cohort ranged between 0.7 and 0.9, indicating they’ve been less sensitive to movements in the broader market. This was likely due to a disparity in sector allocations, which align with the dividend focus. Compared with VTI, these funds were overweight sectors that are traditionally more defensive such as utilities and consumer staples while being underweight the technology and financials sectors.

Mild Value The remaining value funds in this study underperformed VTI during the postcrisis period. Similar to the deep value group, these funds offered relatively pure exposure to the value factor. What distinguished this group from deep value peers was the strength of the value tilts. The loading on the value factor (HML) was lower than the deep value funds. Consequently, this group didn't benefit from the rock-bottom prices on offer during the depths of the 2009 bear market to the same extent that the deep value funds did.

A mild exposure to the value style is directly linked to the process employed to construct these funds’ underlying target indexes. Many of these value-oriented bogies are paired off against a complementary growth portfolio. The approach starts with a broad large-cap universe such as the S&P 500 or the Russell 1000. Stocks in each of these indexes are assigned value and growth scores, then sorted and allocated into value and growth portfolios. All stocks in the parent index are accounted for. Therefore, the value and growth portfolios will include a number of stocks that have only mild growth or value characteristics. The inclusion of these additional stocks ends up watering down their respective growth or value tilts.

The most unfortunate aspect of these funds was their failure to compensate investors for the higher levels of risk, as evidenced by their lower risk-adjusted returns relative to VTI. Their drawdowns were similar to if not more pronounced than VTI (with exception of

The conclusion here is that value funds come in many different flavors. Understanding how a value portfolio is constructed, and the exposure that it provides to the desired style, is an incredibly important aspect of using these funds. Each of these three shades of value provides a different approach to value investing. Funds that tilt more aggressively toward value may provide higher returns, but investors should take time to consider the trade-offs between risk and reward.

References 1. Data from the Ken French Data Library, see Fama/French 5 Factors (2x3).

2. Novy-Marx, R. 2012. "The Other Side of Value: The Gross Profitability Premium."

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