A recent academic study generating buzz in the media confirms what many people already suspected: a lot of value funds aren’t living up to their names.
Adding the word value to a fund’s name is easy. Indeed, more than 500 funds now use the term.1 Yet delivering a true value strategy—one that pursues the higher expected returns that academic researchers have identified—remains challenging.
In a working paper titled “Characteristics of Mutual Fund Portfolios: Where Are the Value Funds?” a group of researchers led by Martin Lettau of the University of California, Berkeley and Sydney C. Ludvigson of New York University shows that very few value funds provide investors with significant exposure to the companies that tend to outperform over longer periods of time.2 (Value stocks trade at a low price relative to the equity that stockholders have in the company. Historical research shows that value stocks tend to outperform growth stocks over longer time horizons.)
“Many active value funds are closet growth funds,” Lettau says in a recent interview with Retirement Income Journal.3 “On average, they hold more growth stocks than value stocks.” It’s a pattern they find to have been consistently true since the 1980s. Lettau points out that Dimensional’s value strategies are an exception.
So why is it so hard to build value funds around actual value stocks? Lettau and his team consider and dismiss several possible theories. It’s not style drift—that is, the tendency of performance-focused managers to load up on stocks that are performing well. Nor is it the fault of the proxies that funds use to define value. The researchers looked primarily at stocks with low price-to-book ratios.4 However, they also considered several alternative criteria—including price-to-earnings ratios and dividend yield—and reached similar conclusions.5
Dimensional draws insights from decades of academic research as well as the firm’s analysis of returns from global markets to understand the most important drivers of expected returns. As Dimensional’s Co-Head of Research, Marlena Lee, says, “If your goal is higher expected returns, you have to identify what drives returns and then use that information efficiently every day. The reason our value strategies have a strong focus on stocks with low price-to-book ratios is because that is how we design and manage them.”
Not all value funds are created equal. Many funds that are branded as value have fallen short on delivering the value premium. When assessing any strategy, value or otherwise, investors should ask, “Has this manager been able to deliver what they committed to deliver?”
1 Lettau, Martin and Ludvigson, Sydney C., and Manoel, Paulo, “Characteristics of Mutual Fund Portfolios: Where Are the Value Funds?” SSRN (December 19, 2018).
3 Pechter, Kerry, “A Genuine ‘Value Fund’ Is Hard to Find,” Retirement Income Journal (February 7, 2019).
4 Price-to-book is the ratio of a firm’s market value to its book value; market value is computed as price times shares outstanding, and book value is the value of stockholder’s equity as reported on a company’s balance sheet.
5 Price-to-earnings is the ratio of a company’s current share price to its earnings per share.
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