Everyone likes an underdog — the beaten-down, diamond-in-the-rough hero who rises to the occasion in tough times. In the world of investing, it’s the job of so-called value funds to seek out such hidden gems by looking for names with the lowest price-to-book ratios.
Ground-breaking research by Eugene Fama and Ken French has found that from 1926 to 2018, value stocks have outperformed growth stocks — those with the highest ratios — by 3.6% on an annual basis. But even with that knowledge, managers of funds that invest in value stocks may be having a tough time sticking to their mandates.
“According to a new study circulated a few weeks ago by the National Bureau of Economic Research, there are hardly any mutual funds or ETFs that consistently invest in the quintile of stocks with the greatest value,” reported MarketWatch columnist Mark Hulbert in a piece published by the Wall Street Journal. The study, titled The Characteristics of Mutual Fund Portfolios: Where are the Value Funds?, analysed a database of thousands of funds and ETFs between 1980 and 2016.
Among all those, the researchers found only two that consistently invested in the top quintile of value stocks. In addition, the average self-described “value” fund were found to hold stocks that are two quintiles away from the most value-focused names, placing them closer to the “growth” end of the spectrum.
Martin Lettau, one of the study’s authors and a finance professor at the University of California, Berkeley, stressed that the finding isn’t due to so-called “style drift,” a phenomenon wherein sustained periods of value lagging growth tempts value fund managers to stray from their mandates. And even using value metrics aside from price-to-book ratios, the researchers reached the same conclusion.
One working theory put forward by Kent Daniel, a finance professor at Columbia University, is that investors and advisors alike succumb to recency bias. Even if they’re aware of the strong historical performance of value over growth, they may find it distasteful to purchase stocks that best fit the criteria for value. “[H]e finds support for this hunch in his research showing that by the time a stock has a low price-to-book ratio, it often has suffered many years of poor price performance,” the Journal piece said.
Extreme-value ETFs are benchmarked to a particular index, which should take manager discretion out of the picture. But the choice of the index to benchmark an ETF against could also be influenced by behavioural factors. Citing Lettau, the Journal report said nearly all of the supposedly value-oriented ETFs were benchmarked to indexes that don’t look at price-to-book ratios or similar metrics to define value.
One approach value-seeking investors can take is to construct their own portfolio of extreme value stocks. But Lettau cautioned that those choosing this route must build a big enough portfolio — with at least 25 stocks — to be adequately diversified.
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