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Raman Aylur Subramanian

Raman Aylur Subramanian
Equity Applied Research

How pure is your value?

Among the reasons that value firms sell at a discount to their intrinsic worth is that they tend to be more sensitive to shocks in gross domestic product compared with their growth counterparts. That may occur because of leverage, deployments of capital, risk-taking or something else that constrains value firms' ability to adapt to macroeconomic stresses.

The phenomenon results in value firms underperforming the broader market in times of uncertainty, including the years since the financial crisis. Over longer periods of time, however, value stocks have outperformed the market, creating a premium that reflects compensation for their exposure to uncertainty in growth expectations.

Some institutional investors are using the underperformance since 2008 as an opportunity to revisit their allocations to the value factor. The challenge is how to boost exposure without taking unwanted sector bets.

That was the situation that recently faced a large U.S. state retirement fund. The fund employs a multi-factor investing framework that captures the premiums historically available from the value, quality and momentum factors. 

The fund’s manager had used a fundamentals-weighted index to capture the value premium. Such indexes decouple an asset’s weight in the index from its price using such attributes as earnings or sales. But the index offered limited exposure to the value factor and contained significant active sector bets.

The manager aimed to boost exposure to value without diminishing its exposure to quality and momentum or reallocating assets from elsewhere in the equity portfolio. For that, the manager turned to the MSCI Enhanced Value Index, which is designed to offer a high level of exposure to value while minimizing unwanted sector bets.

 

Multi-factor with enhanced value has outperformed traditional value since the financial crisis

 

Source: MSCI Research, based on monthly averages between May 31, 1999 and Sept. 30, 2016

 

The charts below show how the MSCI Enhanced Value Index performed as part of a strategy that combines value, quality and momentum.

 

Enhanced value provided better diversification than traditional value

Source: MSCI Research, based on monthly averages between May 31, 1999 and Sept. 30, 2016

 

The new allocation has more exposure to hallmarks of value such as book-to-price and earnings yield. But the allocation also preserved exposure to both momentum and quality, over the 17 years that ended Sept. 30.

 

The MSCI Enhanced Value Index increased exposure to value while preserving momentum and quality

Source: MSCI Research, based on monthly averages between May 31, 1999 and Sept. 30, 2016

 

As the table below suggests, swapping an enhanced value index in place of a value-weighted version improved performance over the sample period, albeit with a slightly higher cost of tracking error and turnover.

 

Source: MSCI Research, based on monthly averages between May 31, 1999 and Sept. 30, 2016

* Gross returns annualized in USD

** Annualized one-way index turnover over index reviews

Investors who focus on the long term may seek a purer exposure to value through all parts of the market cycle. For such investors, a value index that minimizes unintended and unwanted sector bets may be one way to allocate capital efficiently.

 

Further reading:

Finding value

The value factor marks a decade of disappointment

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