Three Shades of Value (Part 2)

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

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Remaining two shades of value - Value plus Profitability & Mild Value - will be discussed in this part.

Value Plus Profitability
The other group of value funds that has outperformed the broader market in the postcrisis period featured lower value loadings than the deep-value ETFs but had exposure to the profitability factor (RMW). Profitability is sometimes used as a proxy for a firm's quality. Many of these funds follow indexes that either screen or weight their holdings on the basis of their dividend payments or yields.

Dividend strategies can cue off measures that may also be indicators of value (dividend yield) and/or profitability (dividend stability or growth). All things being equal, when a company is profitable it may increase the dividends it pays to shareholders. In this instance, a higher dividend payout may signal management's confidence regarding future profitability. On the other hand, dividend yields increase when a stock's price declines. This could result from a slump in a firm's prospects. Thus, a strategy that emphasizes dividends may buy companies that are increasing dividend payments (profitability), those that have experienced recent slump (value), or some combination of the two.

The major benefit of having a portfolio exposed to both value and profitability is that these two strategies can diversify each other. In his paper "The Other Side of Value: The Gross Profitability Premium,"[2] Robert Novy-Marx demonstrated that value and profitability strategies are negatively correlated. Value strategies purchase stocks of companies that are on the ropes, while strategies based on measures of profitability tend to invest in firms with rosier prospects. Therefore, when one strategy is doing poorly, the other is likely performing well.

All the funds I've assigned to this subcategory had a statistically significant loading on the profitability factor. These same funds had value loadings that were lower than those of the deep-value funds. The inclusion of profitable firms helped these funds outperform the broader market from March 2009 through December 2016.

Monetary policy in the postrecession period provides an additional explanation of outperformance. In late 2008, the Federal Reserve began cutting interest rates intending to jump-start economic growth and promote investment. Yields on bonds consequently dropped, leaving investors looking for alternative sources of income. The increased demand for higher-yielding investments was a likely contributor to the excess returns that dividend paying stocks generated relative to VTI.

170622 Threeshadesvalue 01(en)

The marriage of value and profitability also resulted in a smoother ride relative to the deep-value funds. The emphasis on profitability, or quality, produces portfolios with lower betas, ranging between 0.7 and 0.9, indicating they've been less sensitive to movements in the broader market. This was likely because of a disparity in sector allocations, which align with the dividend focus. Compared with VTI, these funds were had overweightings in traditionally more defensive sectors such as utilities and consumer staples and underweightings in the technology and financial sectors.

Mild Value
The remaining value funds in our field of study underperformed VTI during the postcrisis period. Similar to the deep-value group, these funds offered relatively pure exposure to the value factor. What distinguished these funds from their deep-value peers was the strength of their value tilt. Their loading on the value factor (HML) was lower than the deep-value funds'. Consequently, they didn't take advantage of the values on offer during the depths of the bear market in early 2009 to the same extent that the deep-value funds did.

These funds' mild value tilt springs forth from the build of their underlying benchmarks. Many of these mild-value funds' bogies are paired off against a complementary growth portfolio. The approach starts with a broad large-cap universe such as the S&P 500 or the Russell 1000 Index. Stocks in each of these indexes are assigned value and growth scores, then sorted and allocated into either a value or growth portfolio. All stocks in the parent index are accounted for. Therefore, the value and growth portfolios will include a number of stocks that have only mild growth or value characteristics. The inclusion of these additional stocks ends up watering down their respective growth or value tilts.

170622 Threeshadesvalue 02(en)

The most unfortunate aspect of these funds was their failure to compensate investors for the higher levels of risk. With the exception of PowerShares Dynamic Large Cap Value ETF (PWV, listed in the U.S.), these funds' risk-adjusted returns fell short of VTI's. Their drawdowns were similar to if not more pronounced than VTI's. Five out of the eight funds in this categorization were plagued with volatility that was actually greater than or equal to VTI's. Returns in 2009 were lackluster at best as all of them underperformed VTI, when the deep-value funds were taking advantage of ultracheap shares. These funds also had betas that ranged from 0.9 to 1.0, indicating that they behaved very similarly to the broader market.

The conclusion here is that value funds come in many different flavors. Understanding how a value portfolio is constructed, and the exposure that it provides to the desired style, is an incredibly important aspect of using these funds. Each of these three shades of value provides a different approach to value investing. Funds that tilt more aggressively toward value may provide higher returns, but investors should take time to consider the trade-offs between risk and reward.

[2] Novy-Marx, R. 2012. "The Other Side of Value: The Gross Profitability Premium."


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