Many investors are familiar with value investing, whether through Warren Buffet’s investment philosophy or the traditional “style-box” grid used to guide investment decisions.
Value investing is about finding bargains — stocks with lower valuations based on fundamentals. Research suggests that such stocks have historically tended to outperform the market over the long run (source: J. Lakonishok, A. Shleifer, R. Vishny. Contrarian Investment, Extrapolation, and Risk. Journal of Finance, 1994).
Over the last few years, some investors grew cautious of value investing strategies in a low-growth landscape. However, as the global economy improved, investors became more optimistic about the potential of these strategies. This is consistent with research showing that value has typically done well when market trends reverse (source: J. Lakonishok, A. Shleifer, R. Vishny. Contrarian Investment, Extrapolation, and Risk. Journal of Finance, 1994).
Traditionally, devotees of value investing have run their own numbers, or have outsourced that to an advisor or a value mutual fund manager. They also had the option of investing in index funds or ETFs that seek to track value indexes and, as with most passive products, typically cost less than their actively managed counterparts. (For more information about the difference between ETFs and mutual funds, click here.)
“Factor” ETFs — a type of “smart beta” products that have grown more popular in recent years — offer a newer alternative. The main difference between a traditional value index and a factor value index is how they select and weigh their component securities. Traditional indexes are market-capitalization weighted — the larger the company, the more of the index it makes up.
Factor value indexes, on the other hand, weight their underlying stocks based on their relative contribution to the value component — that is, a company with a higher score for value will make up a larger part of the index. The determination of value is based on a number of indicators, such as price-to-book, forward-looking price-to-earnings, and enterprise value-to-cash flow from operating activities. In effect, the more undervalued a company is, the more of the index it will take up (within reason: indexes generally have rules in place to avoid over-exposure to any single company or sector). So these factor value indexes are more strongly ‘tilted’ towards value to than traditional market-cap based indexes.
This post was originally posted on iShares.com
RO Code: 153430
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.