Large-cap value style funds have long been the saddest dogs in US equity investing. Indexed flavors are net negative since the turn of the century and have lagged in nine of the past 10 years. And 2017 is looking to be more of the same – woof!
But wait – now there’s such a thing as a value factor fund. They seem different, maybe even better. One large-cap factor fund, the iShares MSCI Edge USA Value Factor ETF (VLUE), has outperformed all its style-fund namesakes over the past three years. Even more impressive, with a one-year total return of 21%, VLUE stands alone in besting most large-cap growth and broad-market alternatives.
Our question: is this a truly newfangled contraption? Or simply repackaged goods with some beginner’s luck?
We turned to holdings-based analytics specialist Windfactor Research for further insight.
Nathan Tidd, president, Windfactor Investment Research
VLUE is different, no doubt about that, offering far more value than its style-fund counterparts.
However, it is unclear how those differences will impact fund performance next year. A tracking error of 7.8% indicates returns could vary considerably from the broad market, but VLUE has a Windfactor in the mid-40s, quite similar to its large-cap value style counterparts, which suggests that fund risks are relatively balanced. It could go either way.
An equity fund’s Windfactor is the statistical probability the fund will outperform the US market over the next 12 months, expressed as a value ranging between zero if it is the benchmark and 100 if outperformance is ‘historically certain.’ Our research indicates that systematically investing in funds with higher Windfactors would have been a good bet over the past decade and will continue to be so if history keeps repeating itself.
Windfactors are derived from best-match returns, the average and volatility of historical one-year relative returns for similar companies during similar market environments. They leverage a unique business factor model that matches today’s companies with past firms based on criteria such as primary industry, earnings drivers, management policies and market value. Best-match returns are reported in percent relative to the Windfactor US Market Portfolio – a benchmark made up of the top 2,500 US securities by market cap.
Figure 1 shows summary valuation statistics for VLUE alongside funds tracking large-cap value indices from S&P, Russell and Morningstar (IVE, IWX, and JFK respectively). A key difference for VLUE is stock selection based on earnings yield, which stands out at 6.8%, compared with an average of 5.5% for the style funds constructed primarily on price-to-book measures.
Figure 2 shows a high-level price attribution to the distinct sources of intrinsic value (business factors) that Windfactor considers. The analysis shows that, directionally, the pursuit of value is similar across funds. However, VLUE is far more aggressive about it, with far higher concentrations in firms offering above-average industry exposure (measured by revenue) and far lower allocations to:
- Common characteristics that investors typically consider attractive, including revenue growth, cash balances, profitability, equity book value, investment and smaller firms with (presumably) higher growth potential.
- Firm-specific factors that investors expect to lead to above average growth. VLUE industry tilts are also quite different. Where traditional style funds overweight big banks and energy companies, VLUE currently has its money in out-of-favor places such as retailers and motor vehicles.
Figure 3 shows how these differences translate into best-match returns. On average, a historically similar basket of funds would have been no more likely to beat the market than VLUE, but the range of outcomes is far greater, suggesting that next year could be a big surprise in either direction for the factor fund.