Weston Wellington
Vice President, Dimensional Fund Advisors

Value stocks underperformed growth stocks by a material margin in the US last year. However, the magnitude and duration of the recent negative value premium are not unprecedented. This column reviews a previous period when challenging performance caused many to question the benefits of value investing. The subsequent results serve as a reminder about the importance of discipline.

Measured by the difference between the Russell 1000 Growth and Russell 1000 Value indices, value stocks delivered the weakest relative performance in seven years. Moreover, as of year-end 2015, value stocks returned less than growth stocks over the past one, three, five, 10 and 13 years.

Unsurprisingly, some investors with a value tilt to their portfolios are finding their patience sorely tested. We suspect at least a few will find these results sufficiently discouraging and may contemplate abandoning value stocks entirely.

Total Return for 12 Months Ending 31 December 2015
Russell 1000 Growth Index: 5.67%
Russell 1000 Value Index: −3.83%
Value minus Growth: −9.49%

Before taking such a big step, let’s review a previous period when value strategies underperformed to gain some perspective.

As many growth stocks and technology-related firms soared in value in the mid- to late 1990s, value strategies delivered positive returns but fell far behind in the relative performance race. At year-end 1998, value stocks had underperformed growth stocks over the previous one, three, five, 10, 15 and 20 years. The inception of the Russell indices was January 1979, so all the available data (20 years) from the most widely followed benchmarks indicated superior performance for growth stocks. To some investors, it seemed foolish for money managers to hold “old economy” stocks like Caterpillar (−3.1% total return for 1998) while “new economy” stocks like Yahoo! Inc. appeared to be the wave of the future (743% total return for 1998).

Many value-oriented managers counselled patience, but for them the worst was yet to come. In 1999, growth stocks shone even brighter as value trailed by the largest calendar year margin in the history of the Russell indices—over 25%.

Total Return for 1999
Russell 1000 Growth Index: 33.16%
Russell 1000 Value Index: 7.36%
Value minus Growth: −25.80%

In the first quarter of 2000, growth stocks bolted out of the gate and streaked to a 7% return while value stocks returned only 0.48%. As at 31 March 2000, value stocks had underperformed growth stocks by 5.61% per year for the previous 10 years and by 1.49% per year since the inception of the Russell indices in 1979. AWall Street Journal article appearing in January profiled a prominent value-oriented fund manager who regularly received angry letters and email messages; his fund shareholders ridiculed him for avoiding technology-related investments. Two months later he was replaced as portfolio manager amidst persistent shareholder redemptions.

With value stocks falling so far behind in the relative performance race, it seemed plausible that value stocks would need a lifetime to catch up, if they ever could.

It took less than a year.

By November 2000, value stocks had delivered modestly higher returns than growth stocks since index inception (21 years, 11 months). By month-end February 2001, value stocks had outperformed growth over the previous one, three, five, 10 and 20 years and since-inception periods.

The reversal was dramatic. Over the period April 2000 to November, value stocks outperformed growth stocks by 26.7% and by 39.7% from April 2000 to February 2001.

This type of result is not confined to the technology boom-and-bust experience of the late 1990s. Although less pronounced, a similar reversal took place following a lengthy period of value stock underperformance ending in December 1991.

We can find similar evidence with other premiums:

• From January 1995 to December 1999, the annualised size premium was negative by approximately 963 basis points (bps), amounting to a cumulative total return difference of approximately 113%. Within the next 18 months, the entire cumulative difference had been made up.

• From January 1995 to December 2001, the annualised size premium was positive by approximately 157 bps.

The moral of the story?

Prices are difficult to predict at either the individual security level or the asset class level and dramatic changes in relative performance can take place in a short period of time.

While there is a sound economic rationale and empirical evidence to support our expectation that value stocks will outperform growth stocks and small caps will outperform large caps over longer periods, we know that value and small caps can underperform over any given period. Results from previous periods reinforce the importance of discipline in pursuing these premiums.

Financial advisers and private client advisers at banks and broking firms have a long history of buying fixed interest securities as direct holdings for their clients. However, over recent years there has been a shift in behaviour, with fixed interest funds increasingly becoming the solution of choice.

So, what are the pros and cons of each option, and what criteria should matter most to investors?

In this article we discuss a range of criteria, and provide some insights gained from our activities in the domestic fixed interest market.

Does the investment provide the risk and return exposure that is sought, given the investor’s risk appetite and investment objectives?

Investors tend to seek fixed interest as an asset class for its traditional characteristics of income, as well as capital stability. They do this because fixed interest tends to offset the volatility experienced by shares. To offset share volatility effectively, fixed interest investments should be made up exclusively of investment grade bonds (rated between AAA and BBB- on the S&P scale). When share prices fall investors tend to flock to Investment grade securities, pushing up their price. Their price rise offsets the price fall in shares. This cannot be relied on with high yield securities, as investors discovered with the New Zealand finance company collapses.

Here’s the important point – to raise the likelihood of fixed interest investments providing capital stability, diversification is required. An investor who utilises individual securities rather than a fund will likely be limited to only a small number of issuers. In a concentrated portfolio, default, or a significant downgrade by a single issuer, can severely undermine returns at the time the portfolio needs those returns the most.

Again, the failure of finance companies in New Zealand from 2007 – 2010 is a reminder of both the pitfalls of sub-investment grade securities and, in many cases, poor diversification.

For example, below we show the returns of our New Zealand equity strategy in 2007 and 2008 (the heart of the Global Financial Crisis) and a blended portfolio of 50% equities and 50% fixed interest. Note that all returns listed below are after relevant investment management fees.

All returns are net of investment management fees but gross of advice, custodial and transaction costs. Past performance is not indicative of future results. For details on our NZ equity and fixed interest strategy please see consiliumnz.co.nz/disclosure-statement. This clearly shows the potential of a properly diversified investment grade portfolio of fixed interest to offset the volatility of shares at exactly the right time.

Can investors achieve diversification in New Zealand fixed income?

While global fixed interest markets offer significantly greater scope for diversification, it is also possible to achieve a reasonable degree of diversification in New Zealand. It is easier to do this with a fund rather than by selecting direct securities. This is because there are some corporate issuers that only issue to the wholesale market, meaning retail investors cannot buy these securities. If we exclude small local authorities, there are over 90 different issuers available to wholesale investors in New Zealand. Of these, only around 30 can be bought by retail investors directly.

Another challenge for buying New Zealand fixed interest directly is opportunities to invest in new issues. As the number of securities in New Zealand is limited, new issues are very important. A fund can more flexibly and easily add new issues into a broadly diversified portfolio because it can accommodate varying maturity dates and credit qualities. Those buying direct will naturally have more specific maturity, issuer and credit quality requirements, meaning that new issues cannot be easily incorporated into their portfolio.

What costs are involved?

Of course, there is a management fee cost to owning a fund. We pay less than 0.40% for our direct New Zealand fixed interest funds. It’s worth noting that investing in fixed interest via a managed fund actually lowers costs in two important (but often unaccounted for) ways. Firstly, funds pay lower brokerage costs to transact on the exchange, and secondly, funds simply pay less for the same bond via a narrower bid/offer spread for trades not dealt on the exchange. We estimate that these savings are around 0.25% at the time of purchase.

Are there other benefits from professional management?

Fund managers may also be able to add some additional value to help offset their costs. This will vary across funds, depending on the capabilities of the fund manager and the design and investment approach of the fund. As an example, for the three years to June 2015 the Harbour NZ Corporate Bond Fund has generated about 0.12% p.a. of added value over the ANZ Corporate Investment Grade Bond Index, before costs. The relevant issue is perhaps not the 0.12% cost offset, but that no investor buying bonds directly could ever hope to achieve the diversification of the ANZ Corporate Investment Grade Bond Index without incurring very high transaction and monitoring costs. The fact that Harbour can do so, and add a little something back, is a great benefit to investors.

Even if you don’t believe that managers can add value through professional management, their research resources may help avoid the accidents that can occur in small, poorly researched portfolios.

Can term deposits be a solution?

Term deposits (TDs) often provide a higher running yield than a bond fund (after fees) or direct securities (after costs). There is a good argument for holding some exposure to TDs, but they also have different characteristics. Investors typically choose short maturity TDs, of less than one year, because of the severe penalties that occur with early withdrawal. The short length of the TDs may offset the potential added return. To underline this issue, the Reserve Bank and APRA, the Australian regulator, have required Australian banks, and their New Zealand branches or subsidiaries, to tighten up the conditions under which investors can break a TD before maturity. This lack of liquidity may be a problem at times for investors.

Secondly, since TDs have no price mechanism, they do not increase in capital value at times when shares fall, meaning we lose some of the diversification benefit we are seeking through fixed interest securities.

What am I paying my adviser to be an expert in – financial planning or bond markets?

The Code of Professional Conduct requires an authorised financial adviser (AFA) to “make recommendations only in relation to financial products that have been analysed by the AFA to a level that provides a reasonable basis for any such recommendation, or analysed by another person upon whose analysis it is reasonable, in all circumstances, for the AFA to rely.” In our experience, it is a challenge for most advisers to bring together the expertise and resources required to satisfy this requirement in relation to directly held securities. In our view advisers are, and should be, experts in financial planning rather than experts in fixed interest markets. Those who try to be both risk doing both to a lesser standard.

There are several factors to consider when choosing between funds or direct investments in New Zealand fixed interest. Financial planners are accustomed to using funds for investing in equities and overseas asset classes. We believe the underlying investment characteristics of an appropriate fund can be a better proposition than direct securities, due to a fund’s ability to achieve diversification, liquidity and benefit from professional management.

We’d like to thank Harbour Asset Management’s Mark Brown for his assistance with this article.

Important notice and disclaimer

This commentary is given in good faith and has been prepared from published information and other sources believed to be reliable, accurate and complete at the time of preparation but its accuracy and completeness is not guaranteed. Information and any analysis, opinions or views contained herein reflect a judgement at the date of preparation and are subject to change without notice. The information and any analysis, opinions or views made or referred to is for general information purposes only. To the extent that any such content constitutes advice, it does not take into account any person’s particular financial situation or goals, and accordingly, does not constitute personalised financial advice under the Financial Advisers Act 2008, nor does it constitute advice of a legal, tax, accounting or other nature to any person. The bond market is volatile. The price, value and income derived from investments may fluctuate in that values can go down as well as up, and investors may get back less than originally invested. Past performance is not indicative of future results, and no representation or warranty, express or implied, is made regarding future performance. Bonds and bond funds carry interest rate risk (as interest rates rise, bond prices usually fall, and vice versa), inflation risk and issuer credit and default risks. To the maximum extent permitted by law, no liability or responsibility is accepted for any loss or damage, direct or consequential, arising from or in connection with this document or its contents. No person guarantees the performance of funds monitored by Consilium NZ Limited.

The value of shares goes up and down a lot, and all this volatility creates uncertainty for investors.  It’s not very clear, for most investors in shares, exactly what the value of their share portfolio will be at any point in the future.

We’ve been asked why shares are so volatile.  Hopefully this explanation will help.

Shares represent ownership in business.  Shareholders have a claim on the profits the business makes – these profits are paid out as dividends, or reinvested into the company in order to grow future profits.

The most basic model of valuing shares takes both of these inputs – dividends and growth (by growth, we mean growth in profits) – and combines them in an equation to form a price.

The model states that Price (P) equals the next dividend (D₁) divided by my required return (r) minus my expected growth (g).

Put together, the model looks like this:

Let’s try out the model.  We’ll say next year’s dividend is going to be $0.25 per share.  Let’s say I require a 10% return on my investment to make it worth my while, and let’s also say I expected dividends to grow at 4% per year into the future.

The model would say the price =

An investor with the assumptions above would be willing to pay $4.17 for shares.

Now, let’s alter the growth assumptions.  We’ll run one scenario where growth is 3% and another where it’s 5%.

5% growth:

3% growth:

A 1% change in growth doesn’t seem like a big deal – the company is profitable in either case – yet a 1% increase in the growth projection translated into a $0.83/$4.17 = 20% increase in price.  A 1% fall in the growth projection caused a 14% fall in price.

The point of this is to illustrate that changes in projections about future growth (even small ones) can cause big changes in prices.  In the real world, there’s a lot of disagreement about the growth potential of businesses.  This disagreement is good, as it creates willing buyers and sellers.  When buyers and sellers come to some agreement that growth prospects have improved or worsened, prices will move pretty quickly to adjust.

Should you only invest in businesses with high projected growth?

One conclusion you may be tempted to make is to only invest in businesses with high growth forecasts.

That would be the wrong conclusion.

One thing this model points out to us is that an investor should really be indifferent between an investment with 3% growth, an investment with 4% growth and an investment with 5% growth.

Why?

In each case, the price adjusts, so an investor could expect roughly the same return with any of the three growth projections.  What this means is that great companies are not always great investments, and bad companies are not always bad investments.  The important thing to consider is what you are paying to invest in either.  At the right price, you are indifferent.  In fact, evidence suggests that investments with low prices provide higher returns over the long run, even though they often have low growth projections.  This is probably because these companies have poor prospects and investors require higher returns (a higher r from the equation above) to own them.  At any rate, the model helps us understand why this would be the case.

Hopefully this has helped you understand why markets concern themselves so much with growth, and why prices can move so much and so quickly, as well as.  It should also have explained why price movements are so important.  They reset the investment equation so that firms with very different growth potential are actually comparable investments.

How would prices change if growth projections stayed constant?

While the above is useful, it may leave you with the impression that growth rates have to increase for you to get a positive return on your investment.

That isn’t the case.  Prices will still increase in a world where there is no change in growth projections.

Why?

Let’s say that growth doesn’t change.  It stays at a forecasted 4%.  What would happen to prices in that world?

Even in that case we can expect prices to appreciate because of two things:

• In this world, you received the dividend
• In this world, you achieved the forecasted growth

If growth was 4%, next year’s dividend would not be $0.25.  It would be $0.25 plus 4% growth.  It would be $0.26.

Doing the same equation as above, a business with a $0.26 dividend, 4% projected growth and 10% required rate of return would translate into a price of $4.33.  That’s around a 4% increase from $4.17.

You then add your dividend yield to this gain, which is the dividend divided by the price.

Add them together: 4% (capital gain) + 6% (dividend yield) = 10% (return).

Thus, in the default world the price will go up every year, and you’ll get that 10% return every year.  Of course, we also know that rarely occurs.  Economic cycles, business decisions, interest rates and a host of other things each year influence the prospects of businesses to grow profits.  And, if both buyers and sellers agree that growth projections have changed, prices will change quickly to reflect this fact.

By looking at investments this way you can see why shares have an expected return, where that return comes from and that it does not require improvements in forecasted growth to achieve the expected return.

A consideration of the evidence

Short summary of our position on tactical asset allocation

According to Vanguard, “Tactical asset allocation (TAA) is a dynamic strategy that actively adjusts a portfolio’s strategic asset allocation (SAA) based on short term market forecasts.  Its objective is to systematically exploit inefficiencies or temporary imbalances among different asset or sub-asset classes.”

Evidence shows that this approach has failed to deliver on its promised benefits, so we choose to take a different approach.  Rather than time our moves out of expensive asset classes and sectors, we continuously tilt our portfolios towards relatively inexpensive assets, higher returning smaller companies, and profitable companies.  In short, we believe in a consistent and robust process over the crystal ball approach.

We take the following common sense steps to achieve many of the promised benefits of TAA, without the unnecessary risk:

• We provide continuous exposure to assets with higher expected return in a cost effective manner.
• We invest in over 40 countries and 8,000 securities, from the outset reducing exposure to any one country, sector or company that may be problematic.
• We work with advisers to ensure the overall portfolio can achieve the client’s objectives by a comfortable margin.  We recommend reducing risk when it isn’t necessary and increasing it when it is, subject to achieving the financial objective.
• We work with advisers to rebalance portfolios regularly, selling assets with recent good performance and buying assets with recent lower performance.

More detailed explanation of tactical asset allocation

In our view, TAA is simply market timing within a constrained or set portion of the whole portfolio.

For example, an institution may have an SAA of 60% equities and 40% fixed income, but utilisation of TAA may allow the equity allocation to vary between 50% and 70% and the fixed income allocation to vary between 30% and 50%.  This is equivalent to saying that 80% of the portfolio will have a 60/40 allocation, and market timing will be performed with the remaining 20%.  For institutional investors, TAA occurs at two levels – investment consultants allocating funds among different asset class managers and investment fund managers allocating funds among different asset classes and sub-asset classes.

It is our position that TAA is a futile exercise because market timing and style picking are unproductive at best, and potentially destructive at worst.

TAA is normally built on models that rely on ‘signals’ to determine when to go heavy on one asset class, at the expense of another.  A well known example is the ‘Fed Model’, which compares the earnings yield on equities to the yield on 10 year treasury bonds.  If the earnings yield (the inverse of the price-to-earnings ratio) on the S&P 500 were to fall below the 10 year treasury yield, a manager utilising TAA based on the Fed Model would interpret this difference as a clear signal to favour fixed income at the expense of US equities.  The Fed Model, like all the other models used for market timing, has repeatedly been shown to be unreliable in both the short term and the long term.  For further details, see Asness, Clifford, “Fight the Fed Model”, Journal of Portfolio Management, Fall 2003.

TAA at its heart involves predicting the returns of shares, called equities, and dividing a portfolio up between shares and fixed interest based on these predictions.  In one of the most complete research papers of its type, called “A Comprehensive Look at The Empirical Performance of Equity Premium Prediction”, Drs Ivo Welch and Amit Goyal examine 22 common models of TAA and market timing.  They make the following conclusion:

“Our article comprehensively re-examines the performance of variables that have been suggested by the academic literature to be good predictors of the equity premium.  We find that by and large, these models have predicted poorly both in-sample (IS) and out-of-sample (OOS) for 30 years now; these models seem unstable, as diagnosed by their out-of-sample predictions and other statistics; and these models would not have helped an investor with access only to available information to profitably time the Market”

One problem with trying to read market sentiment for timing purposes is that sentiments can endure for years at a time.  As John Maynard Keynes famously remarked, “The market can remain irrational longer than you can remain solvent.”

The reason why all these models are unreliable is so simple that it is easily overlooked.  In three words, prices are fair.  This means that every asset class has thousands of intelligent and informed people opining daily on the risks of the asset class in general, and all the securities contained in the asset class in particular.  As a result of the discovery process, prices are set so that buyers can expect a return that is commensurate with the risk they assume.  If an institution (or a consultant acting on its behalf) decides that an asset class is overvalued and thus should be pared back, the party taking the other side of the trade has the full expectation that they will be compensated appropriately for the risk they are taking.  There is absolutely no reason for the institution or the consultant to assume that it has special proprietary knowledge that the rest of the market is lacking.

Now that our theoretical objections to TAA have been outlined, it would be useful to examine how mutual funds built on TAA have performed.

In a Wall Street Journal article from 2/11/2012, “How Practical is Tactical?“, Jason Zweig looked at 42 mutual funds and exchange traded funds with “tactical” in their name, based on Morningstar data.  These funds were up 6.9% as of the date of his article – an average of five percentage points less than the various indexes they follow, according to Morningstar.

Over the past three years, these funds have gained an annual average of only 4.9%, or more than six points a year behind their benchmarks.  A ‘tortoise portfolio’, which holds a steady 60% in US stocks and 40% in bonds, is up an annual average of 11% over the same period, more than twice the tactical funds’ average return.

Mr Zweig reminds us that two thirds of the tactical funds didn’t exist before the financial crisis erupted in 2008.  The terror of watching stocks lose 60% in value during the crisis was the driving factor for these products, and Wall Street was happy to accommodate this demand.

Supporting this finding, long term research by Index Funds Advisers found that only four of 21 TAA funds with over 20 years of history (based on data collected by Morningstar) had outperformed a buy-hold and rebalance strategy of funds very similar to those used by us.  Of course, this study didn’t include funds that had gone out of business during that time period.

As far as the ability of investment consultants to add value by moving funds from one manager to another, this myth was completely debunked in “Absence of Value: An Analysis of Investment Allocation Decisions by Institutional Plan Sponsors” (Financial Analysts Journal, Nov/Dec 2009).  The authors evaluated over 80,000 investment decisions by trustees and consultants who oversee and advise on plans (typically large scale pools of retirement funds or endowments in the United States).  As the chart below shows, in only two out of 18 years did plan sponsor decisions to move assets from one manager to another add value.  The authors estimate that over $170 billion of investment value was destroyed over the period (1984 to 2007).

To summarise, TAA is simply one more attempt by big banks and others to package up luck and sell it as skill.  Investors are better off with a sensible strategic allocation of low cost funds that reflects an appropriate risk level.  Market timing and style picking should never be utilised for either a portion or the whole of a portfolio.