A smart time to go for value stocks via ETFs?

Research Affiliates, which devises value ETF indices, says that ETFs constructed to capture comparatively cheap or unloved stocks have been in the doldrums in recent years, but could be headed for a re-rating. They are a better long-term bet, says the company. In a recent report it said: "Value strategies generate substantial excess returns in the long run, at least for those who can commit to the strategy despite ups and downs in performance."

In the aftermath of recession or severe down markets value strategies are able to significantly outperform due to their ability to pick up stocks that have been mispriced by markets, but retain good fundamental characteristics. The company claims that its value-weighted FTSE RAFI US 1000 index has outperformed by more than 20 per cent in periods such as the aftermath of the tech bubble and the "darkest hours of the global financial crisis".

Value investing has been an out of favour style during the equity rally of recent years, which has been created by a combination of low interest rates and quantitative easing (QE) in regions such as Japan and Europe. Cheap borrowing costs and low yields have also enabled companies to buy back shares in their businesses at low cost, inflating prices at the lower-quality end of the market. This has also pushed investors towards dividend-paying stocks due to the paltry yields offered by bonds.

Research Affiliates says: "The past two years or so have been characterised by somewhat extraordinary circumstances in which value has been punished across virtually all sectors on a global scale. In other words, it has been winter everywhere for the value-orientated investor. We are writing this missive from the depths of a very painful winter in value land. On a one, three, five and 10-year trailing basis Russell 1000 Value generated solidly negative excess returns".s

However, quality growth stocks have now reached such high valuations that analysts argue that cheap value stocks could be a good buy before the market corrects. A recent FTSE Russell white paper also argues that "under the so-called value effect, stocks with lower price/earnings (PE) ratios have shown a tendency to outperform those with higher PE ratios over the long term."

Value and growth are just two factors within the so-called smart-beta ETF stable of indices weighted by factors other than market capitalisation. Most 'plain vanilla' indices such as the MSCI World or S&P 500 have now been adapted to create indices that weight stocks by value or growth characteristics. Evidence from growth and value-slanted MSCI World, Russell 1000 and S&P 500 indices show that value performance could already be on the turn.

In the year to date, the MSCI World IMI Growth Index has underperformed the MSCI World and MSCI World Value indices, the Russell 100 Growth has underperformed the Russell 1000 and Russell 1000 Value indices, and the S&P 500 Value and parent S&P 500 indices have also outperformed the S&P 500 Growth index.

That has not been the case over the past few years: among US indices, growth has delivered far higher returns than value for the S&P 500 and Russell 1000 on a five-year cumulative return basis. The MSCI World Value index has also underperformed the MSCI World and MSCI World IMI Growth indices, although by less of a margin.

In the UK the PowerShares FTSE RAFI US 1000 UCITS ETF (PRUS) tracks Research Affiliates' FTSE RAFI US 1000 Index. UBS also listed eight new factor-focused ETFs on the London Stock Exchange at the end of 2015, including UBS ETF (LU) Factor MSCI EMU Prime Value UCITS ETF (UD03) and UBS ETF (IE) Factor MSCI USA Prime Value UCITS ETF (UC96), which use valuation metrics such as price-to-book value and PE to select stocks. The methodology also employs a quality screen to avoid companies that are undervalued due to weak balance sheets. These companies are often referred to as value traps.

Relative performance of growth and value indices (% cumulative return and calendar total return %)

Source: Morningstar as at 10 March 2016