The Research Affiliates Challenge: Two anonymous investment strategies compared side-by-side over a 53-year time span. One delivered annualized excess returns of 2.9% at an annualized risk of 16.3%. The other, 1.8% excess returns and 4.3% risk.
Another difference? The first—a buy-and-hold investment in the S&P 500—represented 60% of the average plan’s stock and bond holdings. The second—a value investing approach—made up just 20%.
“Owners of capital should be demanding an overwhelming value bias in their portfolios.”“Value investing is increasingly overlooked as a meaningful contributor in portfolio construction,” wrote Research Affiliates’ John West and Amie Ko. “For many investors, [it] is actually viewed as a risk to be diversified away.”
In a report published this month, the pair tackled the question of why value investing has fallen out of favor in institutional portfolios—while a bias toward equity remains “conventional wisdom in its ability to generate a reliable source of excess return.”
In comparing the two strategies, West and Ko found that the value strategy had a higher win rate over rolling 15- and 3-year periods, as well as smaller excess losses in worst-case return scenarios.
“There seems to be a disconnect,” they wrote. “Owners of capital should be demanding an overwhelming value bias in their portfolios.”
The duo suggested that the current disdain for value is the result of cognitive bias. Soaring stock prices between 1970 and 2015, for example, has led to equities being viewed positively by today’s investors, resulting in a widespread belief in “stocks for the long run.” Value investing, meanwhile, has been “far less buoyant, and the range of outcomes much more modest” over the same 45-year period—causing investors to associate the strategy with less than stellar performance.
But equity outperformance “loses much of its punch” when rising valuations are taken into account, West and Ko argued. Annualized excess returns dropped from 2.8% to 0.8% on a rolling 15-year basis, while the corresponding win rate fell from 82% to just 43%.
The performance of value investments, meanwhile, slightly improved after adjusting for valuation changes—suggesting “the presence of historical structural alpha, not at all reliant on becoming more expensive,” the authors wrote.
“We should acknowledge that cognitive biases may surreptitiously influence our investment decision making,” West and Ko concluded. “We owe it ourselves to question why all long-term sources of excess return are not treated equally in our portfolios.”
The Problem With Value Investing