An ETF Tale of Two Styles (Part 2)

Not only has value historically offered greater returns, but it also tends to declines less in bear markets. In the 2000-2002 bear market, the Dow Jones Wilshire 5000, one of the broadest measures of the U.S. equity market, lost about 40% of its value. Just to scratch back to break even after such a large decline the index would have to increase by two-thirds. A Morningstar study found that in that same three-year stretch more than 80% of U.S. equity funds posted negative returns. However, that was not the case for value funds, as more than 60% of value funds actually managed to eke out positive returns during this period. Avoiding large percentage drawdowns like in 2000-2002 gives value a huge leg up over the long haul.

While value delivers superior returns over the long-term, it can underperform growth for years at a time. Over the past five years both the MSCI and STOXX growth indices have had greater returns and lower volatility than the either the standard EMU or Europe indices, and their value counterparts. Investors need to go back more than ten years to draw a starting line for a track where value has outperformed growth. The lone exception to this rule has been the STOXX Europe Strong Value 20 Index, which has outperformed the STOXX Europe Strong Growth 20 Index since inception in 2007. However, this has come with greater volatility.

Value's long-term outperformance compared to growth can be primarily attributed to the fact that value managers tend to buy future earnings for a lower price than growth managers do. This also holds for passively-managed value indices. Each quarter, these indices will screen their relevant equity universe for value factors, and then rebalance their component holdings. This process rotates the portfolio out of equities that no longer represent value, and into relatively cheaper securities. In some cases a position could be terminated because earnings have completely collapsed, but more often than not, it's because the market has recognised its true worth and has subsequently bid up the price on the asset to the point where it no longer represents a good value. In essence, a value index systematically buys low and sells high. Meanwhile, growth indices will only sell out of a stock if it has stopped growing, at which point the market may have already lost interest, causing the stock's price to fall.

(to be continued)