The average cross correlation is only 0.21. Interestingly, the highest correlations belong to some of the largest developed countries. It should not be a surprise, given the size of its equity market, that the United States has the largest average correlation (0.34) with other countries’ value premia. Canada is not far behind at 0.32. The other countries with correlations above 0.2 are also developed markets. In contrast, Australia and the emerging markets (Brazil, India, and China) exhibit the lowest average correlations.
The low correlations across borders mean that a global portfolio accessing individual countries’ value premia would have less volatility than its average component. However, 60 bps of excess return does not make for a terribly interesting investment option. We need to find higher expected returns in order to create an attractive investment.
Fundamentally Weighted Indices
Long-time readers of Research Affiliates’ publications know that, in the long run, fundamentally weighted strategies tend to outperform cap-weighted value strategies due to the dynamic nature of their value tilt. This dynamic exposure is an inherent by-product of the strategies’ regular rebalances (Hsu, 2014). Like the value premium itself, this excess return is robust across countries. However, the magnitude of long-term excess returns from fundamentally weighted strategies is substantially greater than the premium captured by cap-weighted value style indices (Hsu, 2014).
A cap-weighted value index is constructed in accordance with price-based methodologies. Companies are typically selected by valuation measures such as the price-to-book ratio. Their capitalization-based weights in the index increase as their share prices appreciate; conversely, their weights decline as prices fall. Ironically, the more expensive—and therefore the less like a value stock—a “value” holding becomes, the greater its weight in a cap-weighted value index. Selecting and weighting stocks on the basis of fundamental values (such as sales, cash flow, dividends, and book value), and periodically rebalancing to fundamental weights, breaks this link between a stock’s price and its weight in the portfolio, resulting in added value relative to the cap-weighted index.
Figure 2 illustrates the value added by the Russell Fundamental Index® Series over the period August 1996—June 2014. The median annualized value added by these strategies is 2.2%1 and the return premium is again positive in each country.