Tuesday, August 5, 2008

Is Value just a big bet on Financials?

Recently, the relative performance of Value vs. Growth seems to be driven mainly by the relative performance of Financials.

The chart below shows the relative weights of the Value and Growth indices in the large cap (Russell 1000 Value and Growth), mid cap (Russell Mid-cap Value and Growth) and small cap (Russell 2000 Value and Growth) indices. As you can see, the Value indices have consistent large overweight in Financials across all market cap bands when compared to the Growth indices. By contrast, the Growth indices are overweight Health Care or Technology, depending on when it’s a large cap (Technology) or small cap (Health Care) index.

Given the recent problems that the Financials have had, it’s not surprising that Value has become tilted towards the sector. In this environment, relative returns are becoming dominated by one big bet on Financials.

Investors in Value funds may want to check their fund if that’s the big bet they want to make.


Walt French said...

Roughly a year ago, I heard one of the famous "fundamental indexer" guys say that the strategy had done very well considering how poorly financials had done. Not, that the strategy had done very poorly considering how much his formulas had the fund loaded up with energy stocks. A reminder that there may be more than one perspective useful here.

"Value," as usually measured by the book/price ratio, is one of the grand-daddy factors, with original research going back to the 1950's. Unfortunately, FASB 140 lets firms do pretty much whatever they want with their balance sheet these days, and many firms, if not trying to hide their non-existent book value, are really in the dark about how to mark their other assets. (Somehow, the liabilities seem a bit more clear cut.) So who knows what book/price, the driver of the value split, means these days?

2007 was a real roller coaster for value shops, but those with even halfway decent multi-factor tools were able to distinguish the sharp revaluation of financials from the steady pain of "value" after adjusting for other industries. Managers might not have seen the two effects coming, but they were clear at least in hindsight by mid-year, and it was possible to stay true to the fundamental notions of value investing while avoiding no-visible-means-of-support financials. If the manager was able to translate the wild goings-on into a sound strategy.

Finally, while Financials have taken a beating, and surely, more will fail, there has been a fantastic rebound in many of them; this is a reminder that no matter how clear-cut our understanding of what drives the market, indexing your investments to what everybody else holds sometimes saves your bacon from your being too smart by half.

John said...

I would note that a lot of financial literature excludes the financial stocks from their value portfolios. However, I think that this is very interesting and it would be interesting to look at the historical diversity of sectors used in such classic papers as the Fama-French paper in 93 (or 92 or whatever).

Michael F. Martin said...

Classic marketing misnomer.