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Value ETFs Don’t Add Value

Feb. 16, 2016 11:50 AM ETVTV, VOE, VBR
Marc Gerstein profile picture
Marc Gerstein's Blog
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THIS IS A REPRINT OF AN ARTICLE INITIALLY PUBLISHED ON FORBES.COM

Value is a much revered investment style. It combines the intellectual appeal of a rational foundation (mathematically justifiable price expectations, margins of safety, discounted future cash flows, etc.) with a bit of star appeal (the ability to emulate the likes of Ben Graham, Warren Buffett et. al.). So "Value" versions of popular ETFs would seem to be a no-brainer. Or not.

A Cold Spell

Value has been struggling lately. Over the past 12 months, the 35 Value ETFs in the Portfolio123 database declined 13.42% on average versus a loss of 8.08% for the SPDR S&P 500 ETF ($SPY).

Table 1 shows performance of various sub-categories of ETFs based on company size and method: Standard market cap weighting, Smart Beta (weighting based on factors other than market cap) and Quant (models not necessarily based on Smart Beta weightings).

Table 1 - Value ETF Total Return 2/10/15 - 2/9/16

Benchmark - SP 500 ($SPY)

-8.08%

Benchmark - Russell 2000 ($IWM)

-18.71%

All Value

-13.42%

All Large Cap Value

-10.98%

All Small Cap Value

-15.73%

Standard Value

-12.27%

Standard Large Cap Value

-10.21%

Standard Small Cap Value

-14.36%

Smart Beta Value

-12.83%

Smart Beta Large Cap Value

-12.01%

Smart Beta Small Cap Value

-18.41%

Quant Value

-17.82%

Quant Large Cap Value

-13.52%

Quant Small Cap Value

-26.45%

It's not perfectly awful. It looks like small-cap market-cap weighted Value ETFs outperformed the $IWM benchmark. But lucky-choosing aside, I'm not sure the kind of analysis that might have led an investor to that category is the sort of task ETF investors expect to take on when they decide to track an index.

The Longer Term Is Not Much Better

It's tempting to explain this away by referring to the notion that all styles run hot and cold from time to time but that over the long term, value should shine.

Table 2 summarizes Value ETF performance over a longer period, from 1/2/2001 through the present.

Table 2 - Value ETF Avg. Annl. Total Return 1/2/01 - 2/9/16

Benchmark - SP 500 ($SPY)

6.41%

Benchmark - Russell 2000 ($IWM)

5.93%

All Value

7.12%

All Large Cap Value

6.02%

All Small Cap Value

6.87%

It's not awful, and looks like one does have some chance to come up with a benchmark beater. But on the whole, the results could rightly lead one to wonder whether it's worth the bother to bypass general market ETFs and search for a needle in the value haystack. And none of this supports visions of being another Warren Buffett.

So what's the problem? On paper (i.e. looking at prospectuses), it seems as if the ETFs are getting it right. Details vary from one to another but generally speaking, they identify well-accepted valuation metrics, rank companies accordingly on the basis of some sort of combination, and assign better-ranked stocks (lower valuation metrics) to the Value group, which become the constituents of the Value index being "passively" tracked by the ETFs.

Low Valuation Ratios Aren't Necessarily Better

We've heard time and again how low PE is better than high PE, how low Price/Book is better than high Price/Book, etc. But we don't always ask why. Let's see what happens when we do that.

The whys and wherefores of stock valuation always start with the idea that to justify an investment, a rational person has to expect to receive back more than he or she spends. Hopefully, everybody agree with that.

When the payback is expected to occur in the future, we have to make allowances by using "present value" formulae to convert tomorrow's dollars into today's dollars. That makes sense; so far so good.

When we're talking about stocks, tomorrow's dollars mean dividends and the proceeds of an expected sale. OK. That's obvious.

Since we have no idea when we'll sell and what the future price might be (feel free to think "uh oh"), folks who know a lot more math than I do take us off the hook by giving us a simple formula that assumes a holding period (with ongoing receipt of dividends) equal to forever. This is less simple, but upon reflection, it's hard to argue against it. Anyway, the approach is known as the Dividend Discount Model (DDM) and the formula is:

  • P = D / (R - G)
  • P = price
  • D = dividend
  • R = required rate of return
  • G = expected dividend growth rate

Please, please, please do not try this at home. It's a theoretical foundation that can't be used in the real world because many stocks don't pay dividends (meaning we'd have to post-date the calculation to a future time when we think dividends will be paid and present-value the final number back to today), and because the forecast assumptions are beyond what we humans can plausibly handle (for example, G needs to be a super-mature "infinite" growth assumption in order to get it low enough so the final answer doesn't turn into a negative number). But despite pragmatic limitations, it's invaluable in the way it shows us how to approach stock valuation, how factors work together.

Let's pretend all companies pay 100% of their EPS to shareholders as dividends, and that shareholders of most companies choose to reinvest it back into the business. If we assume shareholders are willing to act as if all EPS is a benefit that accrues directly to them (as seems feasible to anyone who is awake and who pays attention to the markets), that allows us to substitute E for D. and once we do that, all we need is a bit of elementary-school algebra to help us divide each side of the equation by E (which our teachers told us we could do even though back then, most of us figured we'd never need it in the real world, yeah right!) and wind up with this:

  • P / E = 1 / (R - G)

That's incredibly powerful. It tells us that those who claim P/E (or PE) is meaningful are absolutely correct. And better still, I can come up with similar conversions to derive ideal Price/Sales ratios, Price/Book ratios, Price/Cash Flow ratios, etc. So the gurus are right. Value counts!

Now for the potentially bad news: We see proof positive that we cannot assume lower PE is always better. As G (growth expectations) rise, ideal PE get higher. (Try it yourself, you'll see.) So the PEG ratio advocates got that right.

But the PEG folks missed something important. PE does not depend only G. It also depends on R, required return. As R goes up, ideal PE goes down. That should ring a bell. How many talking heads on TV have told us that rising interest rates (a huge component of R) are bad for stocks! They're right.

But everybody seems to have missed something. Risk is also a component of R. (You demand a higher rate of return for riskier investments; if you're unconvinced, Google "capital asset pricing model" and note the role of Beta.) So as risk falls (i.e., as quality increases), ideal PE rises. And as risk rises, PE falls.

Many assume Value is a conservative strategy. It's not. Low PE ratios (and low numbers for other metrics) are associated with more aggressive levels of risk.

Ultimately, though, what we see here is that we cannot ever assume lower PE is always better. It depends on interest rates, risk, and growth expectations.

Making Sense of Value ETF Performance

Knowing what we now know about valuation ratios, we definitely expect Value ETFs to struggle. All else (i.e. risk and growth) being equal, expectation of higher interest is enough to boost R and depress PE.

As to the lackluster long-term record, that, too, is to be expected. If a so-called Value index does not include factors that pull in stocks with higher growth expectations and/or lower risk (better quality), then we have no choice but to expect that said Value index to be of little if any dollars-and-cents benefit to us. And that's what we see: ratio rankings that don't consider R or G. So everything is as expected and all is well with the world (unless you are responsible for marketing one of these Value ETFs in which case all is not well).

This is why I have been unimpressed by Betterment's use of three value ETFs, Vanguard U.S. Large-Cap Value ($VTV), Vanguard U.S. Mid-Cap Value ($VOE) and Vanguard U.S. Small-Cap Value ($VBR) in their robo-portfolios.

Building A Value Strategy

Obviously, when it comes to Value strategies, a statistical overweighting of exposure to a value factor is all talk no action. In essence, bona fide Value is an information arbitrage strategy in which you generate returns by identifying stocks with PEs (and/or other value ratios) that reflect investment-community assumptions of less growth and/or more risk (i.e., less quality) than you think is warranted. This is an area ripe for active investors who make decisions judgmentally case by case (the Warren Buffetts of the world) and "moneyball" strategists who create models designed to identify situations where there is a high probability that such inefficiencies exist. Value ETFs do not fit into either category.

An example of such a "moneyball" strategy is my Cherrypicking the Blue Chips Smart Alpha model, which you can follow for free on Portfolio123. As expected given the threat of rising interest rates (increases in R), the model is down over the past year; by 6.65%. But that's way better than what we saw from Value ETFs which don't consider risk or growth. This model has quite a few factors designed to address those considerations. Since the model debuted with live money on 4/19/13, it returned 54.7%, versus 18.86% for the S&P 500 Equal Weight Index an average of 17.52% for all the Value ETFs.

Analyst's Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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