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
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?”
With all this in mind, you might be asking, how have Dimensional's value mutual funds compared to the alternatives -- actively managed funds and prominent ETFs and index funds? There are several strategies to choose from but isolating the US large-cap value category offers one data point. For the 10 years ending February 2019:
- the DFA US Large Value Fund (DFLVX) returned +17.6% per year.
- the tax-managed version, DFA Tax-Managed US Market-wide Value Fund (DTMMX) earned +18.0%.
- the average return across the actively managed large value category was just +14.6% per year, -3.2% per year less than DFLVX.
- value index funds and ETFs outperformed the average active value manager but did far worse than DFA despite lower fees.
- the Vanguard Value Index (VIVAX) was the best performer across basic index funds but earned only +15.9% per year, -1.7% annually less than DFLVX.
- the iShares S&P 500 Value ETF (IVE) returned +15.2% per year, -2.4% per year less than DFLVX.
- the iShares Russell 1000 Value ETF (IWD) returned +15.1% per year, -2.5% per year less than DFLVX.
Individuals and many advisors have increasingly turned their attention to fees in recent years as the primary determinate of long-term investment returns. But as this study clearly shows, asset allocation and how your investment funds are designed and managed to capture expected returns are far more important contributors to your financial success. You should certainly strive to reduce or eliminate unnecessary costs, but there's more to investing than expense ratios.
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
All expressions of opinion are subject to change. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.
Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.