The Price Your Clients Will Pay for Investing in the Wrong Value Fund
The recent poor performance of value funds has led some investors to illogically shift to products with less exposure to the value factor. The evidence that the value factor has worked over long periods of time means you want more exposure to it, not less.
Over the period 2017 through March 2020, the value premium, as measured by the traditional metric of HML (the return of stocks with high book-to-market minus the return of stocks with low book-to-market), experienced a drawdown of 42%. Other commonly used value metrics such as price-to-earnings and price-to-cash flow experienced similar drawdowns. The result was that when investors in systematic (quantitative) value funds received their quarterly statements in April 2020, they would have noticed that those funds with greater exposure to the value premium than their benchmark index had underperformed for the prior 10 years. This has led many to conclude that something must be wrong with their funds. I will explore why this is a common error that can cause investors to abandon even well-thought-out plans.
I will begin by explaining that not all “passively” managed funds (no individual stock selection or market timing) are created equal. Index-based mutual funds and index-based exchange-traded funds (ETFs) seek to track an underlying securities index and achieve returns that closely correspond to the returns of that index (generally with low fees). However, not all passively managed funds are index funds. There are funds that invest systematically and transparently (passively) in value strategies that do not try to match any index. They create their own fund construction rules, defining their eligible universe with the goal of achieving a certain degree of exposure to common factors such as value, size, momentum, profitability and quality. Since different systematic funds can have different eligible universes, they can perform very differently, even though they may be in the same asset class (such as U.S. small value).
If the funds are truly systematic in implementing their strategy, each will be doing exactly what it is supposed to be doing, yet their returns can be very different. Those differences in returns do not mean that one fund is necessarily better than the other. The differences will be reflected in exposure to the factors that explain returns. While all index funds are commodities (the only difference between two funds matching the same index is likely to be the fund fees), not all systematic funds are commodities. The following simplistic example illustrates this point (data from Morningstar as of March 31, 2020).
The Russell 2000 Value Index is a common benchmark for U.S. small-value funds. The largest ETF based on that index is the iShares Russell 2000 Value ETF (IWN). Dimensional Fund Advisors U.S. Small Cap Value Fund (DFSVX) is the longest running systematic small-value fund that does not track a published index. Examining the holdings of the two funds, you can see how different they are in terms of their exposure to the value factor. While the two funds had similar average market caps (IWN at $1.3 billion and DFSVX at $1.5 billion), the average price-to-earnings (P/E) of IWN was 13.6 versus just 8.5 for DFSVX – the P/E of IWN was 60% higher than that of DFSVX. In terms of price-to-book (P/B), IWN was 0.91 versus 0.68 for DFSVX – the P/B of IWN was 34% higher. In other words, DFSVX was much more “valuey.” Thus, if the ex-post value (realized) premium is negative, you should expect IWN to outperform DFSVX because it has less exposure to a factor with a negative premium. In other words, knowing that the value premium was negative over the last 10 years, we should expect IWN to have outperformed, which it did. Using the backtest tool at Portfolio Visualizer, we see that from April 2010 through March 2020, IWN returned 4.6% per annum versus 4.2% per annum for DFSVX.