As the trend away from active investing towards passive has intensified over the past few years, investors and analysts have been increasingly questioning what the ever increasing volume of cash chasing factors such as value will mean for performance of the styles such as value, growth and low vol.
There is plenty of research which shows that value investing outperforms over the long term, but it is widely acknowledged that value investing only outperforms because buying securities at deeply discounted prices, is generally unappetizing and few nonprofessional investors have the time as well as patience to conduct the level of research required. Low cost funds which are set up to follow a factor such as value have helped make value investing more accessible, but the limitations of these funds means that they are confined to certain highly liquid securities. This means the funds generally ignore smaller, illiquid opportunities where the best value investments can often be found. Instead, funds pile into cheap -looking blue-chip stocks and research is now starting to question if such a strategy can be sold as a ‘value’ fund at all.
Is there any value at all?
The most damning criticism so far of so-called value strategies was published earlier this month in a revised study entitled ‘Facts About Formulaic Value Investing’ published this month by the CFA Institute. The study considers whether robots and computers can effectively pick value stocks based on their current limitations, namely, most funds select ‘value stocks’ by using simple valuation metrics such as price to book and price to earnings. What the researchers found is that by picking stocks using simple ratios such as the price to earnings ratio alone, can be extremely misleading and often leads to losses for investors. Specifically, the study finds that the price to earnings ratio systematically identifies securities with temporarily higher earnings than is realistic, setting the stage for earnings to be revised lower and losses for investors.
The price to book ratio also threw up similar problems. Data shows that the price to book multiple systematically overvalues a company’s assets, write-downs follow and so to investor losses.
Need to do the leg work
Even though this study serves as a warning to investors who believe they can beat the market by buying a simple value style ETF, the fact that using just multiples alone will not help you beat the market should not come as a surprise to traditional value investors. Indeed, Benjamin Graham originally advised against investing simply based on ratios such as market price to book value. And this is where those value investors who are willing to put in the additional legwork are set to profit.
What’s more, there is evidence which shows that value ETFs fail to offer any exposure to the factor at all (along with value, momentum and low volatility factors).
The most revealing evidence on this theme so far comes from David Blitz, Robeco’s Head of Quantitative Equity Research who produced an academic paper on the topic earlier this year. Blitz analyzed the excess returns of all the ETFs that are listed in the US and that invest in US equities and that had at least a 36-month return history at the end of 2015. Data on the risk-free return, market excess return and the size, value and momentum factor returns was obtained from Professor Kenneth French’s online data library. While Blitz’s data shows that many funds offer a large positive exposure to value, momentum and low volatility factors, and equal number show a negative exposure towards these factors and on aggregate, the overall exposure is very close to zero.
The bottom line
If you add the findings from both studies together, it is clear that value ETFs are not the threat many perceive them to be to value investing. The fact that these funds chase low-quality stocks and have on aggregate zero exposure to the strategy, may in fact be more of an opportunity than threat.
Disclosure: the author owns no share mentioned.
