Brave Value Investing

According to Société Générale’s cross asset research team, there are two types of value investor: patient value investors, who seek to benefit from compounding above-average dividend yields offered by quality companies; and brave value investors, who seek to gain from a share price recovery in companies currently discounted by the market. In this expert opinion, andrew lapthorne, head of quantitative equity research at Société Générale, and François millet, lyxor’s product line manager for etFs and Indexing, explain the index concept.

Building a portfolio mixing such types of risk factor strategies is becoming increasingly popular as an alternative to diversifying in the traditional way, by asset class.

Why should an investor consider using a value strategy?

Andrew Lapthorne: As a strategy, value investing has been around for decades. It was first popularised by Ben Graham and David Dodd in the 1930s and has since been adopted by many successful money managers, most notably Warren Buffett.

Many studies have shown that a strategy of buying and holding undervalued stocks has generated superior longterm returns to other strategies, for example buying growth stocks or owning the market as a whole.

There are different approaches to identifying value—for example, selecting the stocks with the lowest ratio of market price to book value, or stocks with high dividends or low price/earnings ratios. But the central theme of these strategies is the same: an investor buys shares that are relatively out of favour but which end up outperforming more glamorous stocks over time.

What are the sources of return of value strategies?

A. L: There’s a lively debate about why value stocks pay a return premium over time. One explanation is that investors are receiving an extra return for owning companies with lower valuations (and therefore a higher risk of financial distress or default).

Another is that the value premium is caused by the irrationality of investors seeking to match or outperform capitalisation-weighted market benchmarks. By chasing higher-momentum growth stocks, these investors leave other stocks undervalued, offering a return premium. In our view both explanations have some merit. Both are consistent with the idea that investors are rewarded for acquiring and owning unpopular stocks.

How do value strategies compare with other “smart beta” or “factor” approaches?

A. L: Value is one of a number of “smart beta” or “factor” strategies. Factor strategies in the equity markets include value, momentum, small-cap and low-volatility. In the fixed income, foreign exchange and commodities markets, factor strategies include momentum and carry.

Building a portfolio using factors is becoming increasingly popular as an alternative to diversifying in the traditional way, by asset class.

SG’s research team has identified that the historical correlations across factor risk premia are lower than correlations across asset classes, and that cross-factor correlations are also more consistent and more robust to shifts in market “regime”.

So buying and holding exposures to factors may be a more dependable way of earning risk premia than, for example, trying to overweight equities versus bonds.

What is the SG Value Beta index? How does it differ from the SG Quality Income index? Are they bo th value indices?

A. L: We think that there are essentially two different types of equity value strategy.

The first offers a return premium from investing in higherquality, less cyclical, lower-leverage companies with above average yields. Such stocks are likely to underperform in a rising market but offer better protection in a downturn. This type of strategy—which we call “patient value”— is represented by the SG Quality Income index and the associated range of Lyxor ETFs. It aims to deliver long-term returns from the compounding of an above-average yield, together with a reduced capital drawdown risk.

the second type of value strategy—which we call “brave value”—focuses on buying under valued stocks during a period of relatively higher risk. An example would be buying BP after the 2010 Deepwater horizon oil spill, before knowing when the oil spill would be capped. the risk of an initial capital loss is higher, but the attraction is that you are buying the stock at a heavy discount to fair value. This “brave value” approach is represented by our new SG Value Beta index.

What have been the long - term returns of the two strategies and how much of the returns have come from capital appreciation and income?

François Millet: Based upon a back-test, both the SG Quality Income and the SG value Beta indices have provided positive long-term returns relative to a Market Cap Index.

over a twenty-year period from 1994, the sg Quality Income index and the sg value Beta index gave average annual returns of 12.3% and 15.4%, respectively, compared to an average return of 8% from the Market Cap Index.

There was a difference in the composition of returns, though. More than half of the average annual return from the SG Quality Income index came from the compounding of dividends. But over 70% of the average annual return of the SG Value Beta index resulted from capital appreciation.

Patient value investing is mainly about yield, whereas brave value investing is mainly about potential share price increases.

What volatility and drawdow n risks are associated with the value beta approach?

F.M: As you might expect from its focus on under valued stocks, the sg value Beta index has had higher volatility historically than the market, with a larger maximum drawdown.

However, the return-to-risk ratio of the sg value Beta index was higher than that of the market index. We characterise the value Beta approach as offering potentially outsized returns with volatility.

What is the methodology of the SG Value Beta index?

A. L: We rank stocks according to their relative valuations within global industry sectors, using the equal-weighted scores of five traditional value factors, all of which have been associated with positive long-term excess returns in academic literature: book value to price, earnings to price, forward earnings to price, EBITDA to enterprise value and free cash flow to price.

We select the cheapest 200 companies worldwide, based upon this value scoring system, and we equalweight them in the index. Only companies with a freefloat market capitalisation exceeding US$1 billion and six-monthly average daily trading volume of US$3 million or more qualify for the starting universe. The index is rebalanced quarterly.

How does the SG Value Beta index compare with value indices from other index providers?

A. L: Over the years, value indices have become relatively more sophisticated in their methodology. For example, until 2003 MSCI sorted stocks into “value” and “growth” categories solely on the basis of companies’ price-to-book ratios. This approach was questioned when in 2002 the MSCI Value index suddenly became more expensive in P/E terms than the MSCI Growth index.

MSCI modified this first-generation value index in 2003, adding earnings and dividend yield to their value scoring system. We would regard Russell’s value index methodology, which focuses on book value-to-price and sales-to-price, as another example of a second-generation value index.

SG’s Quality Income and Value Beta indices are thirdgeneration value indices, using a variety of share pricedependent and fundamental value metrics to determine company rankings.

Our objective in designing the indices was to have a consistent and simple methodology in a realistic and implementable form.

In what market regimes have the SG Value Beta and SG Quality Income indices performed relatively better/worse?

F. M: In the chart below we show the relative performance of the SG Value Beta index and the SG Quality Income index during different market conditions: under strongly rising markets, range-bound markets and strongly falling markets, as well as overall during up months and down months, over a twenty-year period.

The SG Value Beta index has tended to outperform during periods of rising markets, especially strongly rising markets. It tends to underperform the market index slightly during downturns.

The SG Quality Income index tends to lag the overall market index in bull markets but to outperform strongly in bear markets.

How should investors combine the SG Value Beta and SG Quality Income indices in a portfolio?

F. M: The fact that the two indices perform so differently during different market regimes suggests that an investor can obtain significant diversification benefits by combining them in an equity portfolio.

One way of doing this might be a simple 50:50 allocation between the two index strategies.

Alternatively, an investor could seek to invest in either of the two indices using a regime-switching model, for example using statistical forecasting to determine whether to allocate to the more bullish SGVB index or the more defensive SGQI index.

We have shown the relative performance of the SG Value Beta and SG Quality Income indices, together with an equalweighted portfolio investing in the two indices and a regimeswitching model in the chart below. We think the two index strategies are highly complementary.

What country and sector exposures are prominent in the SG Value Beta index?

F. M: Currently, the SG Value Beta index has a substantial overweight position in Japanese stocks and a relative underweight position in the US equity market by comparison with the MSCI World Value index.

From a sector perspective, the SG Value index currently overweights financials and underweights defensive sectors such as healthcare and consumer staples, again by comparison with the MSCI World Value index.

What other value strategies does Lyxor offer in ETF format?

F.M: Lyxor offers ETFs on traditional value indices, such as the Lyxor ETF MSCI Value and the Lyxor ETF Russell 1000 Value, as well as ETFs on third-generation value indices, the Lyxor ETF SG Quality Income and the Lyxor ETF SG Value Beta. The SG value Beta ETF must be considered as an ETF with a high value factor and provides ideal tool in a factor allocation strategy.

How much do these ETFS cost?

F.M: The Lyxor ETF MSCI Value, Lyxor ETF Russell 1000 Value and the Lyxor ETF SG Value Beta have an annual total expense ratio of 0.4%. The Lyxor ETF SG Quality Income has an annual total expense ratio of 0.45%.

These annual fund charges are highly competitive with actively managed value funds. And our analysis shows that very few active value managers have managed to beat the new SG Value Beta index: only 6% of active funds within Morningstar’s Global Large-Cap Value Equity category have done better than the index over the last five years, for example.

How wo uld you summarise the key features of the SG Value Beta index?

A. L: By acting as a complementary strategy to the SG Quality Income index, which was launched in 2012, the SG Value Beta index enables investors to capture the positive risk premium offered by distressed or problem stocks in a systematic, easy-to-understand and transparent way.