The Track Record
Over any short-term period, either growth or value could come out ahead, but in the long-term, the performance data favours value. Low P/B ratios were first identified as a positive factor in expected returns in Fama and French's 1992 paper, 'The Cross-Section of Expected Stock Returns'. In the U.S., Morningstar's Ibbotson Associates has shown that value stocks have outperformed growth and blend stocks by a wide margin since 1927. Author and hedge fund manager Scott Philips estimates that from 1927 to 2011, value has outperformed growth by about 2.5% annually in the U.S. A 1993 paper from Capual, Rowley, and Sharpe, "International Value and Growth Stock Returns" looked at style performance in six different countries from 1981 to 1992 and found that value outperformed growth in each country on both an absolute and risk-adjusted basis. Meanwhile, our own analysis of European equities displayed similar results.
The MSCI Europe style indices have the longest track record amongst their peer group, dating back to 1974. Over that time span, the value index has outperformed the standard MSCI Europe Index by 0.7% annually, and has bested the growth index by 1.6% per annum. The compounding of this 160 basis point average annual outperformance over time matters: a GBP 100 investment in the growth index would have grown to GBP 3,624 between 1974 and 2011, but the same investment in the value index would have grown to GBP 6,192--a cumulative outperformance of nearly 71%.
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.
Indices
The current style-focused ETFs available track indices from one of two index providers; MSCI and STOXX. Let's look at each index providers’ offering in turn.
MSCI uses eight different variables in constructing their eurozone style indices, three forward looking, three current, and two historical:
- Long-term forward earnings per share growth rate
- Short-term forward earnings per share growth rate
- Price-to-12-month-forward earnings ratio
- Current internal growth rate
- Price-to-book ratio
- Dividend yield
- Long-term historical earnings per share growth trend
- Long-term historical sales per share growth trend
For comparison purposes, Morningstar's style ratings place equal emphasis on forward-looking metrics (50%) and historical and current metrics (the remaining 50%).
STOXX offers two different families of style indices covering both Europe and the Eurozone: the STOXX Europe TMI Style Indices and the STOXX Strong Style Indices. The TMI style indices are subsets of the European/Eurozone TMI indices which cover about 95% of the free-float market capitalisation of European equity markets. Companies are divided into growth and value styles through six factors divided equally into forward-looking, historical, and current measures:
- Projected price-to-earnings ratio
- Projected earnings growth
- Trailing price-to-earnings ratio
- Trailing earnings growth
- Price-to-book ratio
- Dividend yield
With only 20 components, the STOXX Strong indices are more concentrated. They also adhere to a unique weighting methodology: the shares of eligible companies are weighed according to each company's style 'purity', as defined by the six factors listed above. They are also subject to a cap which prevents them from representing more than 15% of the index’s value. The STOXX Europe Strong Style Composite 40 index and EURO STOXX Strong Style Composite 40 Index combine both of their relevant style indices.
Stylish ETFs
According to a 1998 paper by John Bogle, "The Implications of Style Analysis for Mutual Fund Performance Evaluation" high returns are directly associated with low fees. A 2000 paper by James Davis, "Mutual Fund Performance and Manager Style" found that the track record for actively-managed style funds compared to their benchmarks is poor. And even when active funds are ranked by their relative value and growth exposures, the highest decile of value funds don't actually hold much in the way of value stocks. Investors looking to add style exposure, and especially value exposure, to their portfolio might find style ETFs to be a suitable alternative.
Style ETFs are available from five different providers, including Amundi, ETFLab, iShares, Lyxor, and UBS. Lyxor and iShares have attracted the most assets and on-exchange trading volume for their style funds, each tracking a different index provider's style indices (STOXX and MSCI respectively).
In summary, the Morningstar Style Box highlights two of the factors, size and style, that have historically been used to described the distinct sources of equity returns. The Style Box is a great tool for investors to use to compare funds, both on a relative basis and against a proper benchmark. Additionally, because value equities have outperformed growth equities across various regions and over a long time horizon, investors can use one of the numerous European equity style ETFs to get value exposure at a lower cost and with greater transparency and liquidity than with a traditional open-ended fund.
