Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 308

The flaw in 'value' index funds

Value index funds have a fundamental flaw.

The problem is not in the principles of 'value investing'. Those are sound, and they trace back to at least 1934, when Benjamin Graham and David Dodd published Security Analysis, where they argue that investors should “be concerned with the intrinsic value of the security and … discrepancies between the intrinsic value and the market price”. Buying stocks at a discount to their intrinsic value makes sense.

For decades, researching companies like this was the only real way to engage in value investing. That changed in 1992, when Eugene Fama and Kenneth French identified the value 'factor' as a source of market-beating returns. If you simply closed your eyes and bought each company that trades at a low multiple of its book value, you could beat the market. Over the very long term, this factor approach to value investing has worked, too.

That didn’t escape the notice of index providers and asset managers, who started creating products to harness the value factor. Today, hundreds of billions of dollars are invested in value index funds and value exchange traded funds (ETFs).

The source of the problem

So if the principles of value investing are sound, and the factor approach works too, what’s the problem with value index funds and ETFs? The issue is in how the simplest and most widely-tracked value indices are constructed.

The world’s biggest value ETFs track major indices such as the S&P, MSCI, Russell, and CRSP. To build their value and growth indices, each of these providers start with two assumptions that have profound consequences:

  • Value and growth are opposites.
  • A stock’s weight in the value index plus its weight in the growth index should equal its weight in the ‘normal’ market index.

Though the shape of the diagram varies, we can argue that the methodology used has a framework that looks something like this:

How value ETFs categorise stocks

How value ETFs categorise stocks

Source: Orbis

For each stock, the index provider looks at one or more valuation measures, like price-to-book, price-to-earnings, and dividend yield, and then ranks all the stocks in the universe. The cheapest stocks get a high ‘value score’ and end up in the top half of the diagram above.

And because many people are interested in growth shares as well, the index providers do a similar exercise with fundamental metrics such as earnings growth. Stocks with the best fundamentals get a high ‘growth score’ and end up on the right side of the diagram above.

So far, so good. In a simplistic way, we know which stocks are cheap and which companies are good.

Why can’t value and growth be friends?

The trouble comes with the next step.

To decide whether a stock should go in the value index, the growth index, or both, the index providers look for purity. Remember, this pre-determined framework sets up ‘cheap stock’ and ‘good company’ as opposites.

In a way, pitting value and growth against each other is similar to assuming that the market is efficient. Cheap stocks must be cheap for a good reason, and expensive ones must be expensive for a good reason. You always get what you pay for, and you always have to pay for what you get. However assuming this sort of efficiency goes against the whole purpose of factor investing!

In their search for purity, the index providers don’t just put all the cheap stocks in the value index as you might expect. Instead, the clearest candidates for the value index are stocks that have high value scores and low growth scores. Rather than calling this ‘value’, you might call it ‘value and anti-quality’. Or ‘cheap junk’. These stocks, we believe in quadrant A, are the core of every big value ETF.

The same thing happens on the growth side. Growth ETFs do not just buy the companies with the best growth. They focus on stocks that have high growth scores and low value scores. Growth and anti-value. Expensive quality only - the stocks in quadrant C.

The rest of the shares aren’t pure. They’re either value and growth, in quadrant B, or neither value nor growth, in quadrant D. These shares get their weights split between the value and growth indices. No stock is left behind!

Strange results

Think for a moment about your perfect stock. For most of us, it would be a profitable, fast-growing company trading at a dirt cheap valuation. In other words, the stock would sit squarely in quadrant B - cheap quality. Buying these stocks is such a good idea that Joel Greenblatt’s ‘magic formula’ book has sold hundreds of thousands of copies. But magic is not what you get in a value or growth ETF.

Instead, you get a bizarre compromise. For the value index, we’ve identified the cheap stocks, and then downweighted the ones with good fundamentals. And for the growth index, we’ve identified the good companies, then downweighted the ones that are cheap. Neither the value nor the growth ETF gets all of the best stocks, and both of them share the expensive junk—stocks that really ought to be left behind. That may be elegant for the construction of an index family, but it is far from ideal if your goal is attractive returns.

The scope of the problem

We can quantify the hit to investors’ returns, using factor data from Kenneth French. Here, we’ve substituted profitability in for growth as a measures of “good companies”, but the returns here are highly correlated with those of commercial value and growth ETFs. And while this data is for the US given the longer available history (back to 1963), the same patterns hold for global shares over a shorter horizon.

From the numbers, it’s clear where you want to be - buying quality at a reasonable price (B) is the clear winner, beating expensive junk (D) by 4.3% p.a. That amounts to a staggering 10x difference in ending wealth over the full 56-year period. But notice that other things work too. If you ignore fundamentals and buy the low-quality stocks (A and D) or ignore valuations and buy the good companies (B and C), you can also get a reasonably nice return. Value works, and quality works.

But as we’ve presented, you don’t get value in the biggest value ETFs. You get value and anti-quality, or cheap junk. And if you buy cheap junk (A) and (½ of B and ½ of D) or expensive quality (C) and (½ of B and ½ of D), you get the same return as buying all the stocks in the universe. It’s not worth the bother.

Solving the problem

The fundamental problem with value ETFs is that we believe, they target stocks with poor fundamentals. Fortunately, this is a fairly easy problem to solve. Don’t be anti-quality, and don’t be anti-value. Be pro both. Try to buy good companies at low prices, be patient, and enjoy the rewards. In other words, get back to value investing in its original sense - purchasing companies at a discount to their intrinsic value.

 

Graeme Shaw and Rob Perrone are Investment Specialists at Orbis Investments, a sponsor of Firstlinks. This report constitutes general advice only and not personal financial or investment advice. It does not take into account the specific investment objectives, financial situation or individual needs of any particular person.

For more articles and papers from Orbis, please click here.

 

RELATED ARTICLES

How do different investing styles work?

Index funds invest in the bad and the good

November 2020 was an historic month for ETFs

banner

Most viewed in recent weeks

Great new ways the Government helps retirees

Last year's retiree checklist of services available was one of our most popular articles. There are some additions for 2021, and while it can take effort to set them up, they can pay off over the long term.

Four simple strategies deliver long-term investing comfort

A long-time advocate of the merits of generating income by investing in industrial companies rather than bonds or deposits checks his 'mothership' chart for the latest results, and continues to feel vindicated.

$100 billion! Five reasons investors are flocking to ETFs

It's not official, but Australian ETFs are clicking over $100 billion right now. It's a remarkable rise, leaving the traditional rivals, the Listed Investment Companies, in their dust. Why are they so popular?

A close look at retiree fears and expectations

Half of Australians retire early due to unexpected circumstances and within timeframes they did not choose, and two-thirds of pre-retirees worry about funding their retirement. But neither are the greatest fear in retirement.

Cut it out ... millionaires are not wealthy

The widespread use of 'millionaire' must stop. Inflation means that the basket of goods and services that cost $1 million in 1960 now requires $15 million. Today, millionaires are not wealthy.

Minister Jane Hume on SMSFs and superannuation reform

Senator Jane Hume presented at the SMSFA conference this week, and we reproduce the full transcript as a guide to what the Government is thinking on superannuation reforms as we head into the next election.

Latest Updates

Investment strategies

Dog-eat-dinner: a tough day in the life of a broker analyst

What do stock analysts do in reporting season, faced with hundreds of company reports? Take a look inside the secret world of broking and the analysts burning the midnight oil for a month, hoping for a special insight.

Shares

What drives Australian versus global equity performance?

We tend to think of the 'stockmarket' as one beast, but it pays to know the drivers of the different parts, especially global versus Australian stocks. The outlook favours global due to better sector exposure.

Shares

Invest in Australian value stocks before it is too late

By now, we know 'growth' stocks have outperformed 'value' for many years and investors look to the future, but there are good reasons why the switch is on, especially as value companies emerge from the pandemic.  

Shares

Gains of a lifetime reward new retail investors

Nobody knows how to pick the bottom of the market, but new investors did well in 2020. They captured most of the returns since the lows, and contrary to popular opinion, they are not punting away on tech stocks. 

Investment strategies

FANMAG: Because FAANGs are so yesterday

FANMAG returns have been strong but not relative to their predecessors. Looking at a broader group of large tech companies, most have lagged the market. Fad-based investing is no substitute for broad diversification.

Overdue overhaul of Australia’s aged care system

To support a better aged care system appropriate to the needs of all Australians, critical changes are needed including a new financing approach. The current system has failed seniors, carers and providers for years. 

Shares

‘Super-defensive equities’ may rescue struggling 60/40 portfolios

The 60/40 portfolio has been the mainstay of 'default' Australian investing, but large allocations to bonds compromise returns when rates are low. Strategies with exposures negatively-correlated to equities are needed.

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use.
Any general advice or class service prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, has been prepared by without reference to your objectives, financial situation or needs. Refer to our Financial Services Guide (FSG) for more information. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.