Thursday, June 21, 2018

The value factor isn't dead, just misapplied

By Michael Hunstad, Guest Columnist

Contrary to popular perception, the value factor has outperformed over the last decade. Investors are losing patience with value strategies. They think the value factor has lost its power, underperforming since 2008. It hasn't. But there’s a difference between the value factor and value strategies. The value factor contributed positively to performance over the past decade. In contrast, many value strategies suffered from inefficiencies in portfolio construction.

Where’s the value?

The cyclical nature of the value factor’s typical return patterns demands patience. For example, the average historical cycle of underperformance of the value factor in developed markets has been approximately four years, based on research conducted by Northern Trust. Nonetheless, value strategies have historically rewarded patience over the longer term.

The firm illustrates the past decade’s apparent break from historical patterns by comparing the rolling three-year historical performance of the MSCI World Value Index to the MSCI World Growth Index (Exhibit 1). Over the 40 years preceding the global financial crisis, the MSCI World Value Index delivered fairly consistent outperformance with periodic cycles of underperformance. This pattern appeared to end abruptly in 2008. Since then, the MSCI World Value Index has underperformed its growth counterpart in nearly every rolling three-year period.

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Value strategy vs. value factor

Some people may use this chart to question whether the value factor works anymore. However, this chart does not represent the performance of the value factor. Instead, it shows the performance of a value strategy. This matters because a value strategy is subject to a number of return drivers including but not limited to value.

When we isolate various factors in Exhibit 2, we get a more accurate view of factor performance. The chart shows that value actually outperformed from 2008 to 2018. In other words, and contrary to popular belief, the value factor contributed positively to returns over the period.

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Your value strategy may be corrupted

So, why have value strategies underperformed? Because many of the underperforming strategies inefficiently targeted the value factor, resulting in undesired or unexpected exposures.

Factor efficiency is a key driver of the risk-adjusted performance of factor-based strategies. We regularly see value indices or strategies without strong risk controls that structurally underweight the information technology sector and that display other industry biases, as well as having significant stock concentration. Furthermore, as the value factor tends to be negatively correlated with the quality and momentum factors, many value strategies are biased toward unfavorable low quality and low momentum stocks.

The negative contribution of these undesired or unexpected exposures overwhelmed the value factor’s outperformance over the past 10 years (Exhibit 3). This happened because, over the past decade, the information technology sector was among the best performers. A few very large information technology stocks significantly outperformed both the sector average and the broader market. As value strategies tended to avoid these stocks, this drove the negative stock-specific return contribution. Further, quality and momentum performed positively over the period, so value strategies’ under-exposure to them contributed to underperformance.

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Strategy design and implementation matter

A robust investment process that explicitly accounts for the uncompensated risks discussed above can overcome such negative contributions. We believe that the value factor is not dead. While we expect the value premium to persist, it is critical to select a value strategy designed to target value precisely.

The views expressed do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of Northern Trust or TEXPERS.

Michael Hunstad
About the Author
Michael Hunstad is the head of quantitative strategies at Northern Trust Asset Management. Prior to joining the firm, he was head of research at Breakwater Capital, a proprietary trading firm and hedge fund. Other roles included the head of quantitative asset allocation at Allstate Investments LLC and quantitative analyst with a long-short equity hedge fund. Hunstad holds a doctorate in mathematics, and master's degree in economics and a master's in quantitative finance. 

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