In December, the S&P 500 slumped as much as 9% at one point, which is one of the worst declines ever recorded in a single month for the leading index.
This decline caught many investors off guard, particularly value investors and equity hedge funds.
Hedge fund declines
In hedge fund letters to investors that have come out over the last couple weeks, most equity managers said they suffered double-digit losses in December and the fourth quarter as a result of the sudden decline, dragging many firms down to a loss for the full year.
Looking at the data, what is really interesting is the fact value actually underperformed the market and growth stocks last year. This runs against the conventional idea that value should outperform in market downturns and volatile periods.
The Russell 2000 Value Index, as defined by the iShares Russell 2000 Value Index exchange-traded fund, ended 2018 down 14.5%, compared to a loss of 6.1% for the S&P 500. In comparison, the iShares Russell 2000 Growth Index ETF fell 9.7%.
At its lowest point, the Value Index was down 18.9% for the month, more than the maximum drawdown for the S&P 500 and several hundred basis points worse than the performance for the Growth Index.
Whichever way you look at it, and whatever data you use, it is clear that in the last month of 2018, value stocks significantly undeformed both growth and the broader market, contrary to historical evidence that shows value outperforms in market downturns.
What happened?
I think this is a fascinating development and one that deserves further attention, particularly from value investors who put their trust in the strategy.
The question is, what is going wrong and does this underperformance suggest value investing is actually dying?
Trying to answer this question is difficult because there are so many variables to consider. I do not think the underperformance signifies value investing is dying, though it does further reinforce the opinion I've had for some time that value investing has changed dramatically over the past two decades and it is no longer the case of just buying the market's cheapest stocks.
When Benjamin Graham first invented the concept of value investing, the world was a very different place. Asset values and asset-heavy industries dominated the stock market, so it was relatively easy to establish the underlying value of every single company. Today, the market is dominated by companies that have billions of dollars invested in non-tangible assets, the value of which is not readily discernible just by looking at the balance sheet.
This seems to imply active value management is now becoming important again. Combing through the performance numbers for some of the most substantial value factor ETFs and passive funds for last year, it has quickly become clear to me that most of these funds underperformed.
On the other hand, a handful of active hedge funds that follow a long-short equity strategy did outperform last year. They didn't just outperform, though, they generated a positive performance for the year.
Millennium Management, founded by Izzy Englander, gained almost 5%. Strictly speaking, this isn't a value fund, but it is an actively managed equity hedge fund. Bill Ackman (Trades, Portfolio)'s Pershing Square Holdings was down about 0.7% for the year.
A bounce back
I'll admit, this doesn't entirely answer the question of whether or not value investing is dead, but it does point to the conclusion that active management is now becoming important again. Also, we should wait until the end of 2019 to get some idea of how value performs both during a downturn and coming out the other side. Figures coming out of actively managed value funds in January show a strong bounce back. If they can maintain this performance throughout 2019, there is an excellent argument to be made that active value investing has made a comeback after a decade of underperformance.
It is likely that passive value investing will continue to struggle, however, as it becomes harder to evaluate intangible assets and a company's competitive advantages using the balance sheet alone.
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