By Jack Forehand (@PracticalQuant) —
Those of us who run value strategies have had more reason to celebrate in the past 9 months than we had in the prior decade combined. While the market has seen a strong run off its bottom in late March, some value funds have seen their returns beat the market by wide margins and have produced the kind of returns we may only see a few times in our lifetimes over such a short period.
This chart shows the returns of some of the value ETFs I follow relative to the S&P 500 off the March bottom. As you can see, the worst fund has nearly doubled the S&P 500, while the best one has almost tripled its returns.
Invesco S&P SmallCap 600 Pure Value ETF (RZV), Avantis U.S. Small Cap Value ETF (AVUV), Vanguard U.S. Value Factor ETF ETF Shares (VFVA) vs. S&P 500
If you look across the value ETF landscape, you will see many similar examples of market beating returns since the market bottomed.
So it seems like it would be obvious to conclude that value investing is back, right? After all, how could value funds produce these kinds of returns without a significant tailwind from the value factor itself?
But as is often the case in investing, the reality behind the scenes is a little more complicated than the way things appear on the surface.
To understand why, let’s look at our ETF Factor tool for RZV, which is the best performer above. Here are its exposures to value, quality, and size, and the individual metrics we use to measure each.
It is clear from the data that this ETF has a lot of exposure to value. It still has among the highest exposures to value in our database despite its huge recent run, and it had even more exposure before that. And if you looked at the other ETFs I mentioned, you would see the same thing.
If you examine the factor profiles of these funds, though, two things stand out in addition to their exposure to value. First, they have a very large size exposure (meaning they are investing heavily in small- and mid-cap stocks). Second, they have a very low quality exposure (meaning that the companies they invest in are toward the bottom of the universe using the quality metrics we use).
To get a clearer picture of what drove the outperformance of these funds, it is important to consider all three of these exposures and not just the value exposure because it is entirely possible that the other factors drove most or all of it.
And when you do that, you will see that is exactly what has happened. When you adjust for quality and size, it turns out that value has not outperformed much at all off the bottom, even though many value funds have more than doubled the market. The value ETFs with the highest quality exposures and least exposure to size have produced performance that is much more in line with the market return.
To look at it another way, let’s say that I had built 3 equal-weight portfolios on March 26th at the market bottom. The first invested in the cheapest decile of stocks in our universe (which excludes microcaps), the second invested in the stocks with the lowest quality, and the third invested in the smallest stocks (without taking into account any other factors).
Here are the returns of these single factor portfolios from the bottom through March 5th of this year
- Value – 145.1%
- Low Quality – 132.6%
- Small Size – 180.4%
Although the value portfolio did outperform the low-quality portfolio by a small margin, you can see how much size and low quality have been driving stock returns in this period.
Is Value Still Dead?
So what are the key takeaways from all of this?
Before I talk about what they are, it might be more important to talk about what they are not. The takeaway is not that value strategies that have performed best off the bottom are poorly constructed. We run some small-cap value strategies that tend to invest in lower quality companies ourselves, so I am certainly not knocking the approach. There is significant debate as to the impact of adding quality to a value strategy and some would argue that value works best on its own rather than being coupled with quality.
I don’t think the biggest takeaway from this has anything to do with the best way to construct a value strategy. Instead, I think the lesson to take from this is that what is going on beneath the surface can often be very different than the way things appear to be at first glance. In this case, the simple conclusion that value investing is back would miss the fact that value is not what has driven much of the return of many value funds in the past year.
In some ways, the details behind the scenes are actually a big positive for value investors. The fact that value hasn’t outperformed as much as many people think also means it remains very cheap relative to growth. And the fact that high quality value companies have underperformed low quality companies means that value investors can get some degree of a free lunch by adding quality to their portfolios without having to give up much value to do it. Value may not be back like many people think it is, but its future could still be a bright one.