Monday 25 June 2007

The Slippery Meaning of "Value" in ETFs and Indexes

Investing in Value stocks through an ETF brings diversification and higher returns to an equity portfolio. That has been proven in finance research published by Fama and French in their famous three factor model of stock returns, available in all its mathematical glory at the Social Science Research Network. The implications for investing are explained in english language at the Index Fund Advisors.

As the old saying goes, there's many a slip between the cup and the lip. When the research-proven notion of Value, which is simply that the price of a stock is cheap based on the ration of the stock's market price to the company's book value (p/b)(book value is simply assets minus liabilities in the financial statements), the meaning of Value gets transformed and expanded by index providers. Index-based ETFs need to have a reference index and they take them from such providers as Morningstar, Russell, MSCI, Standard & Poors and Dow Jones/Wilshire.

The best explanation of the way Value, and other indexes such as large vs small cap are constructed, is here at the Moneychimp.

So what do we find that the index providers have added to the original p/b measure? First, there are additional historical price measures like price/earnings, price/sales and dividend payout ratio. That might not be so bad as the basic principle that the stock is somehow low-priced compared to a fundamental historical measure is still respected. But where the definition of value really starts to take on hocus-pocus falsity is those indexes that include forecasted of such numbers as earnings! What lunacy! That replaces the best guess, as expressed in the price, of the market, whose guess is better, as shown time and again by research, with the guesses of analysts who are more wrong than right,

How do the index providers stack up?
The Bad
  • Russell - "...the Price-to-book ratio and the I/B/E/S forecast long-term growth mean"; affects IWM, IWW
  • MSCI - p/b, dividend yield and 12-months forward earnings /price; affects VBR, VTV
  • Morningstar - 50% weighting on forecasted estimates; affects JKL
  • Dow Jones/Wilshire - uses p/b and p/ projected earnings (see the Moneychimp link above); affects XCV
The Good
  • Standard & Poors - uses p/b, p/cash flow, p/sales and dividend yield; affects IJS, IJR, RZV
It's very disappointing that Vanguard has chosen such a flawed index for its Value funds since the company's funds are better in other respects than those of the competition by having lower fees and greater diversification. VBR and VTV will be leaving my portfolio as a consequence next year.


Anonymous said...

Good post! I think many investors give too little thought to the issues around index construction.

Anonymous said...

All I will say is look what happened in the 2000 to 2002 time frame for the S&P Value. It underperformed both active strategies and other indices. The return stream was more like a growth fund. Why?

The problem starts with the fact that S&P chose p/b as their sole determining factor in constructing their value versus growth indices. Their philosophy was to split the market cap universe in half. In the late 90's a few tech companies grew so large that they dominated the market cap weightings. When the line was drawn in half the "value" index had such "value" stocks as Clear Channel Communications with a 200 PE. Using only price to book as a sole indicator as to what was growth versus value left the strategy open to unintended risk. In fairness to S&P, they have added additional factors which has resulted in a better constructed indice.

For verification, check out the return streams between the Russell style indices and the S&P's.

CanadianInvestor said...

Thanks for the comment. I've taken a look and made a new post today Oct.6 to include charts from Yahoo. Would be interested if you have any further thoughts or elaboration on why the value indexes needed to be changed since I am not yet convinced.

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