Value stocks have become investors’ favorite bet after the style came back last year after a long period of underperformance. But investors can’t just buy value index funds to get exposure to the style. In fact, passive value strategies could even hurt investors’ portfolios, according to asset manager GMO.
That’s because the returns of different value indices may vary widely given each index provider’s approach to determine if a stock belongs to the value style. In a recent paper, GMO’s asset allocation team found that the Vanguard Value Index gained 2.8 percent last month, while the iShares Russell 1000 Value Index and the S&P Composite 1500 Value Index rose 5.1 percent and 7.4 percent, respectively.
Although it’s not surprising that GMO, an active manager, would argue for an active strategy, the data that GMO analyzed and other research supports that view. Lyrical Asset Management, for one, argues that popular value indices are poorly constructed and do not accurately reflect the style.
The disparity in returns of value indices is even more glaring when they are compared with growth stocks. The S&P Composite 1500 Value Index outperformed the S&P Composite Value Index by 1.6 percent last month. Meanwhile, the iShares Russell 1000 Value Index underperformed the iShares Russell 1000 Growth Index by 3.2 percent. Vanguard’s growth index even beat its value counterpart by 7.6 percent in January, according to GMO.
“After a bruising 2022 for equities globally, value stocks in the U.S. have become attractive in an absolute sense and worthy of inclusion in one’s portfolio,” according to the paper. “But the wide range in returns for various value implementations in January 2023 raises the question, What are ‘Value’ stocks?”
Some index investors may also be paying higher prices for lower levels of fundamentals. For example, stocks within the Vanguard Value Index have an average price-to-earnings ratio of 21.1 and a return-on-equity level of 19 percent, whereas stocks within the S&P Composite 1500 Value Index have a price-to-earnings ratio of 25.1 and a return-on-equity of 13 percent. That means S&P’s value index is significantly more expensive than Vanguard’s, according to GMO.
“With so many wide-ranging definitions and outcomes, it is crucial for investors seeking value exposure to choose carefully,” the paper concluded. “To capture the extreme discount of the cheapest quintile of the market, we recommend an active value implementation.”
