Last year we said that value was nearing low ebb. The tide went out a bit further as value ETFs rebounded slower than growth ETFs in late 2010 and early 2011, but the wild swings relative to each other are over. We still see industry sector exposure as the most crucial element in their constant tug of war.
Bucking historical trends, value tanked worse than growth during the Credit Crisis of 2008, and then it rebounded more sharply. This is contrary to accepted wisdom, because value traditionally contains stodgy, conservative firms. This economic cycle, however, started with value ETFs full of banks throwing off cash dividends from earnings of speculative mortgages. Price/Earnings were low and Dividend Yield and Book/Price were high, so these firms fit the definition of value nicely. Then they blew up:
The Russell 3000 Value ETF (NYSEArca:IWW) above dropped nearly 10% more than its mirror image iShares Russell 3000 Growth ETF (NYSEArca:IWZ) during the crucial end of the crash in Spring of 2009.
Much of recent performance of value ETFs vs. growth can be explained by heavy exposure to financials, which is why we currently emphasize sector analysis. Financials constitute over 20% of company holdings in typical value ETFs, compared to under 10% in a typical growth ETF. Financials took it on the chin badly during the Credit Crisis of 2008 and so did value ETFs which overweighted them. Although the "banking effect" should mostly dissipate by the end of 2011, the influence of sectors is still pronounced.
Energy might seem like the most critical new sector, but as we shall see next it will not drive such wide swings in relative performance between value and growth. Utilities, on the other hand, have a better chance of doing so despite their boring reputation.
As one can see from the table below, value is putting its money into financials and utilities, while growth is emphasizing technology and consumer discretionary. A strong or weak showing in any of these sectors will affect one ETF but not the other. Other sectors have more even amounts of firms on each side of the value/growth divide. What happens to these industry sectors will affect IWW or IWZ fairly equally. They are still relevant. Performance will diverge between value and growth companies within these sectors due to macroeconomic factors and affect the performance of the value and growth ETFs which own them. This is just as investors would have it. If all relative performance were driven by sector performance then investors would be better off with sector ETFs.
For example, energy is volatile but is represented about equally in value and growth ETFs, so it is not likely to drive a big swing of one relative to the other. Utilities, however, are heavily affected by energy prices for better or worse, and they are disproportionately represented in value. They are likely to drive differences in relative performance.
|IWW (value) holdings||IWZ (growth) holdings|
|Materials & Processing||3.61%||5.51%|
It might seem counter-intuitive but value (or growth) ETFs are primarily a play on US equities as an asset class, and secondarily a play on half of that market. Some investors buy value as a hedge for a bear market, but even during normal times it only provides a minor hedge. It is most useful for the bullish investor who is confident in picking macroeconomic trends or spotting valuation imbalances. This explains why discussion of value is almost always relative to growth.
Long periods of dominance of one over the other are the norm for value/growth, but the more expensive one becomes relative to the other, the more likely reversion to the mean seems to creep up to reduce the gap. Currently value sports a P/E of about 14 and growth about 16. One normally has to pay a bit more for growth relative to value, but the gap is well within historical norms.
Favoring growth is that the US is in recovery, which is typically when growth companies shine. This recovery, however, is particularly sluggish.
Favoring value is the approximately 1% additional dividend yield its churns out. Investors are seeking income in the current low-yield environment. They are, however, nervous about a spike in interest rates should inflation kick up. Investors seeking higher yields will no doubt flee to high yield bonds at that point, so there is risk.
Value enthusiasts once pointed to research by Fama and French as evidence that value performs better than growth AND at lower risk. In the 1990s when the data looked most convincing, value started a long period of underperformance. Other reserch followed, and fewer academics today believe there is a free lunch or that historical trends portend the future.
A typical value ETF will split up an index and take firms with a low projected price-to-earnings ratio (P/E), earnings growth, price-to-book ratio, and revenue growth, but a high high dividend yield. Formulas vary.
Many fine plain vanilla ETFs serve value at low cost. They are differentiated primarily by the size of firms they address:
The above products have reasonable fees (with Vanguard as usual leading the pack) and are based on well-regarded, modern, capitalization-weighted indexes. SPDR uses Dow Jones Wilshire indexes, while iShares deploys both Russell and S&P indexes, and Vanguard depends on MSCI. It is useful that most ETFs in each line are complementary and have no overlap. By sticking to one product line, an investor can overweight one asset class with clarity and precision. Among the exceptions is iShares' IWW which is a nearly total market product, Vanguard's VTV which is the sum of MGV and VOE, SPDR's ELV which overlaps other Wilshire ETFs in mid-cap and likewise iShares' IWS.
There are also funds through Rydex and Morningstar which claim to more accurately capture value as a concept in their index methodologies. They tend to be a little more expensive:
There are also several ETFs based on proprietary enhanced or fundamental indexes. These funds sometimes deliver higher returns, sometimes lower:
And finally there are short and leverage value ETFs suitable for speculative traders looking for a short-term play: