By Hiromichi Tamura, head of investment research and Alex Chen, regional head, equity index research, APAC
In recent years, Value has underperformed other factors in global equity markets. However, the sources of Value performance are not identical—it’s worth observing the differences in the sources of Value by region.
What do we mean by value?
We define the Value factor as a combination of E/P (Earnings Yield), CF/P (Cash Flow Yield) and country relative S/P (Sales to Price Ratio). Our Value indexes are formed using the "tilt" approach, which adjusts the weights of individual stocks according to the Value of their factor exposures.
Any Value index is influenced to an extent by specific sectors, or even other factors (Quality, Momentum, Low Volatility, Size, etc.). It could be argued that the Value factor return includes those correlations. But, as our paper sets out, it is also true that the performance of Value has historically been affected by other-than-value factors (so-called off-target). As shown in Figure.1, Value portfolio tends to overweight stocks that are of lower quality, more volatile than the market, smaller in size and have fallen in price.
Needless to say, these off-target exposures will affect the performance of Value. Table 1 presents the performance attribution results of Value by using of a cross-sectional regressions. From Table 1, we observe the following:
- In the case of US conventional Value, the contribution of Value to total excess return is low. Instead, excess return arises mainly from the Size and Volatility factors. The Value return of US has been "bulked up" by returns attributable to non-Value factors and industries, with the return contribution of Value itself being low. In other words, the US value return is not coming from Value itself.
- Similarly in Europe and Japan, Size exposure contributes substantially to excess return, being second only to Value in terms of contribution.
So, what should we do if we want to minimize the effect of off-target exposures? One practical way is to construct Value index using FTSE Russell’s Target Exposure methodology, which neutralizes the influence of off-targets. Figure 2 shows the average active factor exposures of the this approach in each region. This approach delivers comparable levels of active exposure to Value, but minimizes off-target factor exposures. The merit of this factor purity allows the Value index to capture the Value premium without distortions from other unintended style factors.
Figure 3 shows the cumulative performance of the conventional approach and Target Exposure methodology for each region. The latter exhibited more stable performance because there is minimal tracking errors contributed from off-targets.
The performance of value in the Covid-19 turmoil has certainly led some investors to question the effectiveness of value strategies. However, as you can see in the most recent part of the chart, value has also shown a remarkable recovery following the COVID-19 vaccination programme. For investors who believe in a long-term value strategy, whether to view value in conventional or target factor is an important point in constructing an investment strategy.
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