Value's underperformance highlights systemic problem with smart beta

Tom Eckett

a group of trees in a desert

With the Q2 edition of Beyond Beta out this week, it seems appropriate for this note to focus on the world of factor investing and one factor in particular that continues to dominate the headlines, value.

Although the concept of value investing has been around since the days of Benjamin Graham and his renowned book, the Intelligent Investor, the factor has somewhat hit a snag in the road since the Global Financial Crisis.

Over this period, value has consistently underperformed a market that has been propped up by central bank’s huge quantitative-easing programmes except for brief periods in 2009 and 2016.

At the start of the year, calls were being made for 2020 to be the year of the value investor, who had been patiently waiting for something to go their way.

For example, a JP Morgan research note in February said value could “outperform in either a recession or in a reflationary environment”.

One of these environments became a reality after the rapid spread of coronavirus sent shockwaves through financial markets which posted their biggest falls since the Global Financial Crisis.

However, value failed to outperform in either the drop when oil prices were hammered or during the subsequent rebound causing questions around whether the factor is dead to once again bubble to the surface.

Highlighting this – to take the most broad-based of indices – the MSCI World Value index returned -29.2% in Q1 versus -23.2% for the MSCI World. However, when markets started to rally in April the MSCI World outperformed its value relative by 2.3%.

Experts such as quant investing pioneer, Cliff Asness, co-founder and CIO of AQR Capital Management, have rushed to defend value in recent weeks.

In a white paper, Asness said value is “super cheap” today simply because investors are “paying way more than usual for the stocks they love versus the ones they hate”.

“It has certainly been excruciating getting here, but here we are, and it has never looked cheaper going forward,” he concluded.

However, as highlighted in my Beyond Beta article, value’s demise could be a sign of something far more systemic in smart beta products.

And that is the problem that factors are based on flimsy academic research that have been produced simply to be published and receive funding.

Cynical I know but it is an issue rife across the whole of academia and the factor investing landscape is no different.

As Dylan Grice, co-founder of Calderwood Capital Research, argued: “The financial products which are based on [smart beta] will ultimately return negative alpha as today’s army of supposed ‘value investors’ (i.e. those following the value ‘factor’ strategy) have already discovered.

“It will die a slow death, as the eventual realisation sets in several years hence, that poor performance is intrinsic to its shoddy research approach.”

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