Valuing Value
At the turn of the 19th Century, more than 13 million hogs made their way to Chicago each year. In fact, Chicago was responsible for supplying more than 80% of the meat consumed in the entire US.
“Hog Butcher for the World” became Chicago’s nickname. Positioned amongst thousands of farms and the epicenter of train travel, farmers brought their livestock to Chicago’s Union Stockyards to be prepped and shipped to their final destination.
The butcher industry has had lastingeffects in Chicago’s famous steakhouses. Offering porterhouses, filets, NY strip and everything in between, the steak menus are vast. It’s the customers job to find the right cut and preparation for their liking.
The menu for investment index funds is equally comprehensive. It can feel like having every Chicago steakhouse menu on your table and buying just one steak. Simply buying a fund with the name “Value” will not suffice.
Through academic research and practitioner application, value index funds typically consist of companies with low price-to-earnings, price-to-book value and price-to-cash-flow ratios. Unfortunately, investors automatically assume this means that the value index only includes companies with these characteristics. Surprisingly, this is not the case.
Below is a graphic exhibiting the overlap in Standard & Poor’s Index Funds.
Out of the 505 stocks in the S&P 500, 34% of the stocks are in both the S&P500 Growth and Value Index Funds. This is possible because of the index construction rules. When you sort the list of companies for specific characteristics, these rules can allow for a company to be both a Growth and Value company.
The main positive effect is that the Value Index can more closely trade the S&P 500 Index because the Value Index contains so many of the 500 constituents. However, the idea of buying growth stocks in a value index is counterintuitive.
For discerning investors looking for investments in only Value companies, the Pure Value Index presents an attractive opportunity. The Pure Value Index further refines an investors exposure to value metrics and limits investments to only those value companies.
For investors, the difference in these two flavors of value means differing risk and returns.
Compared to the traditional S&P 500 Value Index, the Pure Value Index exhibits significantly more volatility. With a 10-year standard deviation that is 48% greater than the Value Index, investors must take note of this increased risk in the Pure Value Index. Intuitively, it makes sense that riskier stocks would exhibit greater price volatility. With half as many stocks as the traditional Value Index, the Pure Value Index also has fewer companies to balance out risk.
In order for an investor to accept more price sensitivity, there must be an accompanying difference in performance. When comparing 5- and 10-year returns, the risk and underlying index attributes explain differences in performance. With the value effect fully documented, investments in only value stocks should yield stronger long-term performance.
Shown graphically, the difference in 10-year returns is striking.
It is critical to remember though that included in this 10-year performance is underperformance over the prior 5 years. Strong, long-term performance still suffer extended periods of lagging performance. This is where the investor must understand the rationale behind the performance and remain committed.
Reviewing returns on an annual basis helps translate risk and index constituency into tangible results. The Pure Value Index’s increased risk and stronger exposure to value helps performance in strong return years such as 2009, 2012, and 2013. Conversely, the traditional S&P 500 Value Index outperforms in down years of 2018 and 2015. The Pure Value Index’s increased volatility translates into annual returns with higher-highs and lower-lows.
Given the choice between the two index funds, an investor can select their flavor of value. A diluted version that contains a blend of value and growth stocks or a purer version with deeper value and no growth stocks. Within those two indices are differing risk and return expectations, and unlike active mutual funds, where a manager can make discretionary trades, these index funds have rules that can give comfort to investors.
Just like a steakhouse menu, fund options have similar names. It is the responsibility of today’s investor to investigate, understand and confirm that they are invested in the index fund that meets their intentions. The difference in index construction and methodology can have significant effects on one’s portfolio, including unintended outcomes.
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An index is an unmanaged portfolio of specific securities, the performance of which is often used as a benchmark in judging the relative performance of certain asset classes. Investors cannot invest directly in an index. An index does not charge management fees or brokerage expenses, and no such fees or expenses were deducted from the performance shown. The information herein was obtained from various sources. Delta Wealth Advisors does not guarantee the accuracy or completeness of information provided by third parties. The information in this report is given as of the date indicated and believed to be reliable. Delta Wealth Advisers assumes no obligation to update this information, or to advise on further developments relating to it.
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