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Three Shades of Value (Part 1)

The different methodologies used by value funds can affect their style tilt and performance.

Daniel Sotiroff 15/06/17

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 revert 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 December 2016, the Russell 1000 Value Index underperformed the broader Russell 1000 Index by almost 1.5 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 December 2016, the Russell 1000 Index again outpaced the Russell 1000 Value Index, in this instance by 16 basis points annually. That's not a huge difference, but it's notable considering value strategies are associated with higher expected returns. 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, and many of them are actively managed. Here, I'll look more closely at a select subset of funds within the large-value Morningstar Category. My sample is dominated by index-tracking ETFs with at least 10-years of returns. I've also included DFA U.S. Large Cap Value (DFLVX, listed in the U.S.) as it employs a systematic, rules-based strategy. All of these were investable as of this writing.

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 December 2016, 10 of these funds beat  Vanguard Total Stock Market ETF (VTI, listed in the U.S.). Some downright killed it--generating excess returns of more than 2 percentage points annually. There were also a fair number (eight) that underperformed during this period. At a high level, this shows that there may be more to a value fund than is implied by its name or category membership.

To investigate this further I ran a four-factor regression using data from the French 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 helped me place the funds in my sample into three different subcategories: deep value, value plus profitability, and mild value.

Deep Value
Funds that were classified as deep value had the heaviest loadings on HML. 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 construction and weighting methodologies, but there are some similarities. All tend to have overweightings in the smallest and cheapest companies in their respective selection universes. These weightings are based on several fundamental metrics such as price/book, price/earnings, and price/sales.

These funds own the cheapest of the cheap stocks. Rebalancing into ultracheap shares at the market's lowest point helped these funds outperform VTI in 2009 as the recovery got under way. DFA U.S. Large Cap Value, PowerShares FTSE RAFI U.S. 1000 ETF (PRF, listed in the U.S.), and Guggenheim S&P 500 Pure Value ETF (RPV, listed in the U.S.) had excess returns of more than 2 percentage points over VTI from March 2009 through December 2016. RPV had the best returns of the bunch, outpacing VTI by 8.6 percentage points annually.

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 category. Their standard deviations and betas were among the highest of any of the funds included in this study.

In part 2 of this article, we will explore the remaining two shades of value.

[1] Data from the Ken French Data Library, see Fama/French 5 Factors (2x3). http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html.

 

 

About Author Daniel Sotiroff

Daniel Sotiroff  

Daniel Sotiroff is an analyst, passive strategies research, for Morningstar.

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