Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Value stocks have been out of favor for the past several years. Joining me to discuss how to invest in value stocks with an exchange-traded fund is Ben Johnson, director of global ETF research for Morningstar.
Ben, thank you for being here.
Ben Johnson: I'm glad to be here, Christine.
Benz: Ben, let's discuss the performance pattern that value stocks have exhibited. Over long periods of time, value stocks have shown a propensity to outperform, but they have been in a little bit of a drought recently.
Johnson: They have absolutely been in a drought. If you look at the performance of the Russell 3000 Value Index relative to its counterpart, the Russell 3000 Growth Index, it's struggled quite mightily over the past few years, dating back to the relative performance peak between these, the days back when value was winning over growth. If you look at the period from August 2008 through the end of 2015, the Growth Index outperformed the Value Index by 3.9 percentage points on an annualized basis. It's been a long and very difficult stretch for value investors relative to growth investors.
Benz: Value investors were really vindicated in the early part of the 00s, though. Coming out of the technology bubble bursting, they performed very, very well.
Johnson: That's absolutely the case. At the end of the day, these are styles. And like any style, they will go into and out of vogue. Value investors today are feeling a bit like they are showing up to fashion week wearing bell bottoms.
Benz: Which may be back in style, but that's a separate topic.
Let's discuss the flows that we've seen. You keep an eye what investors seem to be preferring in terms of their fund choices. It looks like some investors are losing the faith in value investing.
Johnson: I did an analysis across U.S. mutual funds and ETFs as divided up into our Morningstar large-blend, large-growth, and large-value categories. I tracked those on a 12-month basis over the course of a number of years. What you've seen is that very recently, toward the end of 2015, the trend in terms of flows in value funds has become negative. It appears as though investors are beginning to capitulate and give up on value. And what we've seen historically is that it's exactly this sort of capitulation, this sort of behavioral function, that may actually lead to the existence, the creation, the persistence of the value premium.
Value exists because there are suckers on the other side of the poker table willing to take the flipside of the value bet. They are betting on growth or something else. Real, true, strong hands at that poker table, in all likelihood will continue for many years to come, to reap the benefits of that value bet, assuming that they are strong hands. What we are seeing right now is that there are some weak hands at the table, and they are giving up. They are folding.
Benz: You talked about this in the latest issue of ETFInvestor. You looked at this phenomenon, and then you also looked at how different the funds are, the ETFs are, in terms of how they approach value. It's not as simple as just saying, I will go and buy this value ETF. There are lots of different permutations.
If investors are compelled by the idea that value stocks may be cheap, people may be capitulating, and it could be a good time to buy, let's discuss some of the key things that they should have in mind as they are attempting to sort among these different strategies that are plying the value realm.
Johnson: First and foremost, what I would stress is that it is critical not to take what's on the label at face value. There are a whole host of exchange-traded funds that have "value" appearing somewhere in their name, and no two are created alike. There are very vanilla-style value indices that underlie the first generation of value ETFs, things like the iShares Russell 1000 Value ETF or the Vanguard Value ETF.
More recently, we've seen the emergence of ETFs that track indexes that look to more finely capture value, to capture it in a more potent form. An example would be the Guggenheim S&P 500 Pure Value ETF. Depending on how these various benchmarks screen for value characteristics and then look to weight their constituents, you get varying degrees of exposure to the value premium as it's defined in academia, as it's defined by practitioners. And it can vary quite widely depending on what's going on under the hood. It's important to parse the details of the index methodology and understand just how much exposure to value am I getting and what subsequently does that mean in terms of the risk and return profile of that portfolio?
Benz: A more vanilla fund like Vanguard Value ETF, would that tend to be less out of step with the broad market at various points in time, whereas maybe the pure distillation of value stocks like the Guggenheim fund that you mentioned, would tend to experience more boom and bust cycles?
Johnson: That's exactly the case. Something like the Vanguard Value Fund, which is market capitalization-weighted, will have a low degree of tracking error relative to the broad market. It's going to be generally highly correlated with the market. It's never going to stray too far in one direction or another, given that that value bet is somewhat more muted, more diluted, than it is in the case of something like the Guggenheim ETF, where that value bet is more concentrated. It's more pure, and what that results in is a greater degree of tracking error relative to the broad market, a greater degree of volatility in that portfolio. What that's yielded, at least historically, is greater returns albeit with a greater level of risk.
Benz: Be aware of what else you have in your portfolio, I assume, would be part of your guidance. Know yourself as an investor and your ability to tolerate those boom-and-bust cycles. Are those the two funds you would recommend for investors who are looking to investigate potential undervaluation in the value part of the market?
Johnson: Absolutely. If you look at the Vanguard Value Fund, it's a very low cost way to get a more dilute, more muted exposure to the value premium. If you feel as though your hand might not be that strong, if you look back at how value has suffered relative to growth over the course of the better part of a decade now, and you think you might not be able to stick with it to be around to reap the rewards of value, that ETF from a behavioral perspective will be a more palatable option.
If you feel like you are a very strong hand, you are a dyed-in-the-wool value investor, you've got a very long time horizon, and more than enough tolerance for risk in tracking error relative to the broad market, something more potent like the Guggenheim S&P 500 Pure Value ETF is probably a better option for you.
Benz: Ben, lots of interesting insights here for contrarian types. Thank you so much for being here.
Johnson: I'm glad to be here. Thanks for having me.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.