Determining the ETF Value Risk Factor

Includes: VB, VBK, VBR, VO, VOE, VOT
by: Lowell Herr

Fama-French’s value risk factor is at the heart of their paper, "The Cross-Section of Expected Stock Returns." This link connects you to an abstract of their paper. It takes someone like William Bernstein to explain the research study and its importance. Let me quote from "The Intelligent Asset Allocator." The first sentence below refers to some tables in his book.

Most readers will recognize the high-yielding (cheap) group as "terrible" companies, and the low-yielding (expensive) as "good" companies. Probably the most impressive work in this area was done by Professors Fama and French, published in the Journal of Finance in June 1992. They exhaustively studied stock returns from July 1963 through December 1990 and found that all of the variation in return among stocks could be explained by just two factors: company size (no surprise here) and P/B. [P/B is Price/Book/Share] They divided their stock database into 10 groups ranging from the lowest P/B (cheapest) to the highest P/B (most expensive). The cheapest one-tenth of the market returned 19.6% annually, and the most expensive tenth, 7.7% annually. The smallest cheapest stocks returned 23% annually. They also found P/E useful, but not nearly as useful as P/B. After taking P/B into consideration, P/E has no predictive value.

The FF study demonstrates that value stocks have had higher returns than the broad market. Value is determined in the F-F study by the Price/Book ratio. Cheap stocks outperform expensive stocks, and by cheap we mean stocks with a low P/B ratio.

Ferri writes, “Like the size factor the value factor cannot be diversified away by adding more value stocks; hence, value has its own unique risk factor.”

Once more, to enhance the performance of the portfolio, increase the percentage of equities in the mid- and small-value asset classes. The data I have going back to 1989 also supports this thesis.

Speaking in ETF terms, over-weight VBR compared to VBK and hold a higher percentage of VOE vs. VOT. I know one investor who will use mid- and small-cap core holdings (VO and VB) instead of VOT and VBK. This is another way to skew or tilt the portfolio toward the value side of the investing spectrum.

Here is a great quote from Bernstein that sums up this blog post: "Good companies are generally bad stocks, and bad companies are generally good stocks."

This is the type of research we use when building our portfolios and I think this is one of the reasons we perform quite well vs. the benchmarks as Vanguard's Total Market Index Fund, the VTSMX.