A Modern Approach to Value Investing

Factor Tilts
July 21, 2020

“We saw that the expected returns or anticipated returns rule is inadequate. Let us now consider the expected returns–variance of returns (E-V) rule.”

—Harry Markowitz “Portfolio Selection” (1952)

For 10 years, investors have been asking "when will Value be back?"1

The Russell 1000 Value Index lagged the Russell 1000 Index by more than 100 percentage points over the 10-year period ending in June 2020. Despite this dismal performance, some asset managers contend that “rumors of Value’s death may be premature,” emphasizing their belief that fundamentals play an important role in future stock returns and pointing to a distinguished library of research dating back to Benjamin Graham and David Dodd’s 1934 treatise, Security Analysis. Still, 10 years can feel like a long time when you’re behind. So, what happened?

Rank-and-chop portfolio construction explains the lag.

A simple way to create a Value portfolio is to underweight securities that rank low on Value indicators. A version of this rank-and-chop2 methodology, popularized by Eugene Fama and Kenneth French in the 1990s and used by many asset managers today, is the basis of the Russell 1000 Value Index. Between July 2010 and June 2020, Facebook, Amazon, Apple, Microsoft, and Google (FAAMG) were ranked and mostly chopped out of the Russell 1000 Value Index, accounting for more than 3/5 of the lag.

Figure 1: Contributions to active return of the Russell 1000 Value Index versus the Russell 1000 Index by FAAMG stocks over the period July 2010–June 2020.

Optimization achieves a targeted Value exposure while controlling risk.

Rank-and-chop portfolio construction neglects the “V” in Markowitz’s E-V rule by failing to control risk. Our 2016 research shows that an Optimized Value strategy achieved the same exposure as rank-and-chop Value with less than half the tracking error between 1991 and 2014.3

We update our 2016 study by comparing the Russell 1000 Value Index and Optimized Value. While Optimized Value still lagged the Russell 1000 Index over the 10-year period ending in June 2020, the lag was dwarfed by the underperformance of the Russell 1000 Value Index.

Figure 2: Cumulative active return to the Russell 1000 Value Index and a hypothetical strategy, Optimized Value, relative to the Russell 1000 Index, July 2010–June 2020.

FAAMGS explain the difference. They were nearly absent from the Russell 1000 Value Index, while risk control allowed Optimized Value to hold on to them while meeting Value targets.

Figure 3: Average weights of FAAMG stocks in the Russell 1000 Index, a hypothetical Optimized Value strategy, and the Russell 1000 Value Index, over the period July 2010–June 2020.

Risk control may be the modern approach to Value investing.

When will Value be back? The distinguished library of research on Value investing and its support from practitioners may inspire confidence, but it does not answer this question. What we can say is that Optimized Value, a strategy that is distinguished by the incorporation of the “V” in Harry Markowitz’s E-V rule, effectively tracked a diversified benchmark in the past. Risk control is old but timeless, and it will remain an essential element of all Aperio strategies as we move forward into an unknowable future.


Read our paper "Better Value with Risk Control" for a deeper exploration into this subject.


Send questions or comments to blog@aperiogroup.com.

1 “Value” is a term of art that refers to a broad collection of investment strategies that typically depend on financial ratios such as book-to-price and earnings yield.
2 “Rank and chop” is a neologism for a commonly used portfolio construction methodology that ranks securities by an indicator and chops out securities whose ranks fall below a prescribed threshold.
3 Ran Leshem, Lisa R. Goldberg, and Alan Cummings, “Optimizing Value,” Journal of Portfolio Management 42, no. 2 (Winter 2016): 77–89, DOI: doi.org/10.3905/jpm.2016.42.2.077.

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