Value Indexing: Don’t Chase Performance

In a recent interview conducted by Alex Bryan of Morningstar, Research Affiliates’ John West, head of client strategies, discussed a different approach to value investing in which holdings are weighted based on fundamental metrics such as book value and sales rather than market capitalization.

West shared insights concerning the motivation behind the process and how it comprises a value approach:

The motivation, West says, came from the tech bubble during which cap weighting of overpriced stocks forced investors to “go along for the ride.” When the reverse happens, says West, you have a maximum weighting for underperforming securities, resulting in a drag on returns. So, Research Affiliates found that by swapping in some different metrics such as low cost, low turnover and economic representation, they could address the pressure on returns. The value tilt, he says, comes from the focus on how big a company will be in the future as opposed to how big it is now.

In fundamental indexing, as something becomes more and more expensive, it continually rebalances against that. So, it takes a larger value tilt. Essentially “doubling down” on names as they become cheaper.

Research Affiliates recently published data showing that valuations could be used to select stocks with higher potential returns as well as identify factors that are likely to offer better performance going forward. West explains that if factor returns occur mostly due to rising valuations, “that’s a dangerous thing to extrapolate forward. So, we want to say, what would the return be if you didn’t have those rising valuations? Or what would the return be if those valuations don’t rise and actually start to fall?”

West concludes by advising investors to set expectations appropriately and guard against anchoring to past performance. Bryan summarizes, “Look at valuations that tell you more about where things are heading.”