Value-oriented ETFs may be buying expensive stocks just because they are cheaper comparatively with peers in their respective domestic markets, according to Schroders fund manager Ian Kelly.
Over a longer timeframe, the value style has outperformed growth, as shown below. But, the manager argues that ETFs intended to capture the performance of value plays may not be investing in the right stocks.
Source: Bloomberg
Considering the MSCI World Value index, Kelly says stocks are either classes as ‘value’ or ‘growth’ by the index provider into the so-called ‘sausage machine’ that produces the ETFs
Despite guidance from the index provider on how stocks are weighted within the index and assurance that some stocks are assigned partial weights across both value and growth indices, Kelly says the vast majority of components sit in one of either.
He said: “Of the 1,654 stocks in the MSCI World index at December 2016, only 208 – just one in eight – were partially assigned to both indices.
“With 678 stocks going exclusively into the MSCI World Value index and 768 into the MSCI World Growth index, meanwhile, you might think of the value/growth assessment process as different types of meat being prepared for the sausage machine.
“Most stocks enter the mincer and come out into just one container – either marked ‘value’ or ‘growth’.
“As at December 2016, for example, 90.5 per cent of the weight of investments in the MSCI World Value were only present in that index – as opposed to its growth counterpart – meaning fewer than one in 10 were stocks where there had been a ‘smart’ splitting of the business to reflects its growth-and-value nature.”
Kelly added: “What this all means, therefore, is we are left with a value index that is buying roughly the cheaper half of the market while ascribing significantly more capital to the largest stocks.”
The manager said the problem this raises, in the eyes of the Schroders value team, is that the largest stocks in the cheaper half of the market “are really not that cheap”.
Performance of MSCI World Value index over 3yrs
Source: FE Analytics
Kelly says the largest 20 investments in the index represented 26 per cent of the total. Capitalisations of these stocks range between $141bn and $480bn and on average traded at 22 times the 10-year average earnings.
“The reason so many expensive stocks are in the index, we suspect, is because ‘value’ is defined as being cheap in the context of the country in which the stock is listed,” the manager explained.
“Thus, if the US market is expensive on the whole – as we believe it is – then a stock could make it into the MSCI World Value index simply by virtue of being less horrendously overvalued than its compatriots.”
Kelly says investors should buy value on a global basis, weighing stocks on whether they are cheap compared with other stocks around the world rather than comparing them with listed stocks from the same market.
The Schroders value team has previously suggested that index providers favour larger companies but may not suit end investors who take a particular investment view on investment styles.
“What if you thought now could be a good time to buy value stocks?” asked Kelly, noting that value has just gone through its worst decade relative to growth investing since 1937.
Performance of MSCI World Value vs MSCI World Growth over 10yrs
Source: FE Analytics
Kelly says active share – which measures the extent to which fund holding weightings differ from those of a benchmark – may reveal inefficiencies.
“Now, when we consider the active share of the MSCI World Value ETF in relation to the broader MSCI World index, we find it is just 22.7 per cent,” he said.
“In other words, if that ETF were an active fund manager picking value stocks, it could rightly be branded a ‘closet tracker’.
“Certainly, you could take the view that, rather than tracking ‘true value’, a market capitalisation-weighted value ETF is a closet tracker of the broader index.”