Sergiy: The performance of the value factor has been rather dismal from about 2015, 2016, up to possibly the Covid crisis. So during that period, we saw publications doubting the value factor, on the one side. And trying to fix the value factor on the other side. And there is a lot of discussion in academia among practitioners, if the value factor is still there and if it can be exposed.
Paul: Welcome to Index Ideas from FTSE Russell. I'm Paul Amery your podcast host. In this podcast, we look into how FTSE Russell indices are built and why. We explore index ideas that can help you address real-world investment challenges. As a reminder to listeners, you can't invest in an index, and so the concepts that we explore in the podcast are not investment advice. Any reference to potential investment strategies is intended for informational and educational purposes only.
In this episode of the FTSE Russell Index Ideas podcast, we retention to one of the most famous equity market anomalies the value effect. In 1934, Benjamin Graham and David Dodd wrote a classic book showing that stocks with lower book values, in other words value stocks, tend to earn higher returns, than the rest of the stock market over time. In 1992, economists Eugene Fama and Kenneth French published famous study showing that value is one of the three factors driving stock returns, that later earned a Nobel Prize for that piece of research. However, in the last decade, amidst the boom in technology stocks, value investing has run into trouble. Value stocks have performed poorly and some investors have even questioned whether the value factor exists at all. So can value investing be saved?
To help answer that question. I'm joined by Sergiy Lesyk, who is director of research and analytics at FTSE Russell. Sergiy, welcome to Index Ideas.
Sergiy: Thank you very much, Paul.
Paul: Sergiy, the value premium is perhaps the best established, best known equity market factor. Why have some people started questioning whether it works?
Sergiy: First of all, its performance. The performance of the value factor has been rather dismal from about 2015, 2016, up to possibly the Covid crisis. So during that period we saw a lot of publications doubting the value factor on the one side and trying to fix factor on the other side. And there was a lot of discussion in academia and among practitioners if the factor is still there and if it can be exploited.
Paul: And which recent market trends have made value investing so hard?
Sergiy: My view and it's shared by a number of academics, is that the macroeconomic environment in the period from about 2015 to the Covid era was rather special. We saw a dramatic decline in the interest rate globally, in the developed field, particularly in the US, in Europe, to almost zero. And that created a rather unusual backdrop for the stocks and for the value factor. So I think this is one of the drivers of the value factor performance during the period.
Paul: Why is the way that we measure the value factor also open to question?
Sergiy: The classic definition is using the book value and at the time, Fama and French published their works, the structure of the stock market and the companies were dramatically different from what we see now. And it specifically relates to the intangibles. They became much more prominent on the balance sheet and the activities of the company in the last of decades. So one of the issues, some of the academics highlighted with the value is that it doesn't take into account the intangibles or doesn't taking to account properly when you use book value for the value factor definition.
Paul: Thank you for explaining that. So, how does FTSE Russell do it? How do we calculate the value factor?
Sergiy: We look at it from a different angle. We do recognise that book value, can be, if not manipulated, but distorted and give a false impression about the value of the company. So we are using other issues. First of all, we are using not a single ratio, but a composite of three: cash flow-to-price, earnings yield and sales-to-price.
Paul: Sergiy, why does a single value factor portfolio, a pure value factor portfolio, have exposures to other factors? We can call them off-target exposures or intended exposures.
Sergiy: This is a fantastic question, and what we found in our recent research is that the construction of the value index can be significantly impacted by the methodology of the construction. And in the early days of the factor investing, the approach was rather simplistic. You could do sort and selection by one factor or two factors. And you can derive equity premium and factor premium. The factor investing got very popular, and a simplistic approach was erased by the arbitrage in the market. So the correlation between the value factor and other factors creates this phenomenon when a simplistic approach to value factor index creation, creates this so called off-target exposures where instead of pure value factor exposure you get some other negative exposure to quality for example, or negative exposure to momentum. Which creates a drag on the performance of your factor portfolio.
Paul: Thanks for that Sergiy, but why do those exposures matter?
Sergiy: Well, you can say your value factor portfolio is contaminated, and this contamination is large enough to drag and distort performance of your value portfolio because negative exposure to momentum and negative exposure to quality typically contributes negative performance to the whole portfolio. So if you remove these exposures to quality and momentum, your portfolio performance improves.
Paul: And how can the Index designer remove off-target or undesired factor exposures from the value portfolio?
Sergiy: This is first of all index construction methodology. The simplistic sort and selection methodology is not good enough because it does not allow us to remove off-target factor exposures. So there are two most popular index construction methodologies, multiple tilting, this is our flagship index construction methodology, and optimisation. Both methodologies are fit for purpose, so you can either target specific exposure to value and specific zero exposure to other factors using multiple tilt methodology. Or you can use an optimiser, another methodology which can create a portfolio for you at every rebalance targeting specific value exposure and zero exposure to the other factors.
Paul: So which one of those methodologies does FTSE Russell prefer to use?
Sergiy: Historically, we have used multiple-tilt methodology, but we have recently developed our own in-house risk model. And we started offering our clients optimisation methodologies as well.
Paul: Thanks for explaining that, Sergiy. Which other exposures, for example country or industry exposures, might the index designer wish to remove from the portfolio?
Sergiy: Again, the historical approach was that the exposures to countries or industry sectors are passing, so they erase each other over time. But we have also discovered that country and, specifically, industry biases are quite persistent. And if you look over the last 20 years, the valuations of, for example, technology and financials were quite sticky, so the biases to the industries are not neutralising itself over time. So we also discovered that if you neutralise this industry and country exposure, the performance of the value factor index gets even better.
Paul: Based on our back tests Sergiy, what impact do these neutralisation steps have on the value factor portfolio's risk and return?
Sergiy: The neutralisation has a dramatic impact on the performance and more importantly, not only performance, but also information ratio. Just to give you a couple of numbers to illustrate. If we just take our non-neutralised value index, where we have off-target exposures present and some industry and country bets, the performance relative to the underlying market capitalisation index is actually negative, negative 5 basis points. If you neutralise off-target factor exposures, it becomes positive, small 13 basis points per annum, but still positive. And if you neutralise industry and country exposures on top of the off-target factor exposure. It becomes very impressive 32 basis points per annum over the last 20 years. But what is most dramatic is that the information ratio is becoming very significant from -0.3. If you don't neutralise anything to very significant .43 for the industry, country and off-target exposures neutralised.
Paul: Thanks for explaining that, Sergiy. Is there a trade-off here if we use a more neutralised value index, do we have to compromise on the index's liquidity and capacity?
Sergiy: Obviously you can't get anything for nothing, so there is a cost. But the cost is not that significant. Of course, what happens is when you neutralise off-target exposures, you neutralise industry and country exposures. You decrease your opportunity set. So you pay what I think is a small price in terms of diversification, for example, your capacity ratio is going up, but not significantly from 1.19 to 1.26. I don't think it's a significant increase in the capacity ratio. And it's the weighted capacity over the whole universe.
Paul: Thanks for explaining that, and finally, where can podcast listeners go to find out more about this subject?
Sergiy: We have a website, FTSE Russell website, where we publish our research, longer pieces and smaller blogs which are easy to read, and you're welcome to send us any questions if you have any following you reading our research.
Paul: Sergiy, thank you for taking the time to join FTSE Russell Index Ideas to talk about the value factor.
Sergiy: Thank you very much, Paul.
Paul: That's it for this episode of Index Ideas. If you've enjoyed the conversation, then please follow us and give us a rating or review on your podcast app of choice. If you would like to get with the show, you can do so via the email address,
[email protected], but for now, from me, Paul Amery, goodbye.
