Today, many academics and industry practitioners interpret the value investment strategy as capturing mean-reversion in stock valuation ratios. Under this interpretation, rebalancing against price is critical for exploiting the long-horizon mean-reversion. Applying cap-weighting to “value” stocks eliminates, substantially, the opportunity to exploit mean-reversion.
By contrast, some of the better constructed Smart Beta value indices offer more modern approaches to capturing the value premium. Let me use the Fundamental Index strategy as an illustration.
Because the Fundamental Index approach weights stocks by size fundamentals such as book value and total cash flows, and since these size-related fundamentals track capitalization over time, the Fundamental Index strategy generally contains industry exposures that are reasonably similar to the broad market index. For example, as of September 30, 2013, the FTSE RAFI® US 1000 Index held 21.0% in the financial sector and 11.7% in energy stocks (compared to 26.8% and 14.7% in the Russell 1000 Value index). Thus, much of the active shares of fundamentals-weighted indices are taken up by intra-industry bets—for instance, overweighting Ford and underweighting Tesla. Industry based active shares only become large if an industry becomes significantly more expensive relative to its own historical valuation level.
The Fundamental Index also rebalances annually against valuation ratio movements, buying what has become cheaper over the course of the year and selling what has become more expensive. The rebalancing is effected over hundreds of stocks across all industries. This, in effect, amplifies the weak time-series price mean-reversion effect through the law of large numbers in the equity cross-section.
The Fundamental Index’s approach to value investing thus results in approximately 200 bps of historical outperformance3 substantially higher than the traditional value indices’ value-added returns. In the period from December 31, 1978 through September 30, 2013—the longest period for which data are available—the annualized return of the FTSE RAFI U.S. 1000 Index was more than 200 bps higher than the returns of the S&P 500 Index and the Russell 1000 Index, respectively. By contrast, the S&P 500 Value Index beat the S&P 500 by approximately 3 bps and the Russell 1000 Value Index surpassed the Russell 1000 Index by 49 bps. (Table 3.)