Investing in high dividend indices could allow passive investors to capture the value rally that is playing out in markets while offering more chance of avoiding ‘value traps’, according to Vanguard strategists. 
Much of the past decade has seen growth stocks surge – buoyed by the low economic growth, low interest rate backdrop – while value has struggled to make ground.
However, the global ‘re-opening’ from the coronavirus pandemic has led to a revival of the value style; at the same time, growth stocks sitting on lofty valuations have been underperforming.
Performance of growth and value since ‘Pfizer Monday’
Source: FE Analytics
Although June has seen growth stocks rally hard and value struggle once more, Vanguard – and many other investors – think the value style has a good chance of leading the market for the coming years as economic growth rebounds, inflation rises and central banks start to consider lifting interest rates. These are conditions that tend to favour value while holding back growth stocks.
Viktor Nossek, head of investment and product analytics at Vanguard Europe, said: “With value stocks now starting to outperform their growth counterparts — a trend that our research suggests could persist over the next decade — is allocating to value indices the only way to exploit this rotation?
“Or is there an alternative approach to effectively capture the value factor that can help avoid some of the unintended consequences of traditional value strategies?”
Value investing can be an attractive option because it offers the potential for attractive risk-adjusted returns at relatively low price-to-value multiples, Nossek pointed out. However, it can also expose investors to ‘value traps’ – or stocks where low valuations come with weak fundamentals.
“In other words, while some value stocks can offer investors latent returns, others may be priced by the market consensus at cheap valuations with good reason,” he explained.
“Viewed through the lens of the Fama–French five-factor model, value traps are those stocks whose excess returns are sensitive to the value factor (that is, the excess returns of cheap over expensive stocks) but not to the profitability factor (the excess returns of high- over low-profitability stocks).”
Nossek decomposed the returns of the MSCI World Enhanced Value and FTSE All World High Dividend Yield indices over a 13-year period to show their exposures to various factors. The results can be seen in the below chart.
Fama & French factor loadings - high-dividend and value factor exposures
Source: Bloomberg, Fama & French Data Library, Vanguard. Data from 1 May 2008 to 31 Mar 2021, using monthly data and the longest joint data history available for the indices shown. Both indices are net returns in USD.
As would be expected, the value index has a heavy loading towards the value factor - but it comes with minimal loading towards profitability. Nossek said this suggests the value index tilts towards stocks with overall low profitability.
“Certain high-dividend exposures — such as the FTSE All-World High Dividend Yield index — on the other hand, not only capture the value factor (albeit with slightly less sensitivity than value strategies); they also score highly on the profitability factor, offering greater exposure to companies with robust profitability,” he continued.
“By tilting away from ‘deep-value’ propositions that are typically included in traditional value strategies, high-dividend strategies can help investors to mitigate the risk of value traps.”
Nossek explained that part of the reason this is the case is down to how the two indices are constructed.
Market-cap-weighted high-dividend indices such as FTSE All-World High Dividend Yield screen constituents by dividend yield then weight them according to market capitalisation. Because weighting by market cap tends to favour more profitable companies, this means the index scores strongly on the profitability factor.
Many value indices, however, weight their constituents mainly on their value factor scores and don’t look at market cap, which allows more companies with low profitability scores to be included.
The Vanguard strategist added that accessing value opportunities through high-dividend exposures can help passive investors avoid some of the sector biases that tend to come with some value indices.
He noted that many investors would expect a value index to give limited exposure to tech stocks (given the dominance of big tech companies in the growth universe) but MSCI World Enhanced Value has weighting to 21 per cent to the information technology sector.
The FTSE All World High Dividend Yield index, on the other hand, has a tech sector weighting of around half of this at 11 per cent.
Sector weights – high-dividend and value factor exposures
Source: Vanguard, Bloomberg. Data as at 30 Apr 2021
“The financial sector is another case in point,” Nossek said. “Amid the prospect of rising interest rates, steepening yield curves and heightened inflation risks, many investors might view financials as a lynchpin of a value portfolio which should thrive in such an environment.”
But it might surprise some that financials made up around 14 per cent of the MSCI World Enhanced Value index, but more than one-quarter of the FTSE All World High Dividend Yield index.
In addition, Vanguard suggested that passive investors seeking exposure to the value style take into consideration the diversification benefits of the indices they choose.
The MSCI World Enhanced Value index is made up of just 400 stocks, compared with more than 1,600 in the FTSE All World High Dividend Yield index. Vanguard noted that the greater diversification of high-dividend indices means they could also be less volatile than their value counterparts.
Nossek finished: “As investors consider the contrasting fortunes of growth versus value, they should also think about how they gain exposure to these factors.
“High-dividend yield strategies can be much more than just a source of income. They can also offer diversified exposures that capture the value factor with lower volatility than traditional value strategies while helping to mitigate value traps.”