- By Mark Marex, Product Development Specialist, Nasdaq Global Information Services
Despite sounding like a relatively straightforward investment strategy, Value is multifaceted, with considerable nuance. The most basic implementation of Value investing seeks out companies with low price-to-book ratios, with the belief that these “cheap” firms command a higher risk premium for a reason, and will ultimately deliver better-than-average returns in the future. While many such plain-vanilla products exist in the world of passive indexing and ETFs, they are almost uniformly lacking in one crucial area: screening out what are known as value “traps.” In other words, companies that are “cheap for a reason,” and present no compelling investment case based on their other financial and/or qualitative metrics.
The Nasdaq US Contrarian Value Index (launched on June 26, 2017) attempts to tackle this problem by introducing a more refined approach. Beginning with the constituents of the Nasdaq US Large Mid Cap Index, the index methodology ranks all Financials separate from non-Financials (excluding Utilities) stocks on book yield (i.e., book value divided by price) for the most recent 28 quarters, and calculates the median book yield of the benchmark. This is a crucial distinction from other more common approaches, as Financials & Utilities tend to score differently from other sectors on valuation metrics that consider book value. To observe this dynamic visually, it is illustrative to compare the sector weightings of the Nasdaq US 500 Large Cap Index to that of its Value offshoot, the Nasdaq US 500 Large Cap Value Index (which is simply the top-50% of large cap constituents ranked according to Value metrics including book value to price, sales to enterprise value, and earnings to price):
As we can see, Financials are materially over-weighted via standard Value metrics, as are firms in the Oil & Gas space, while Technology firms are materially under-weighted. Separately, Utilities make up 5% of the total weight in the Nasdaq US 500 Large Cap Value Index.
Another notable distinction is the methodology’s consideration of underlying market conditions. If the most recent median book yield of the benchmark is greater than 2 standard deviations plus the average of the median for the last 28 quarters, the market condition is classified as a “bear market”; otherwise, it is classified as a “normal market.” This leads to further disparities in how valuation and other metrics are applied.
If it’s a “bear market” then the top 3 deciles by most recent book yield are selected as the final basket. If it’s a “normal market” then we must calculate leverage (net debt/EBITDA), 12-month price volatility, and forward earnings dispersion for the most recent quarter; then we determine the ranks and deciles of each constituent. Finally, we calculate the “adjusted book yield rank” by placing any securities in the top 3 deciles by book yield at the 50th percentile, if any of their additional 3 factors rank in the 9th or 10th deciles. Once completed, we re-rank all the constituents. While we repeat the process annually to rebalance, the index methodology must evaluate the market condition on a quarterly basis.
We can most directly observe the impact of these methodological differences by comparing the sector weightings of the Nasdaq US Contrarian Value Index to both the Nasdaq US 500 Large Cap Index as well as the Nasdaq US 500 Large Cap Value Index. Overall, the Contrarian Value Index materially underweighted Technology (but less so than the Nasdaq US 500 Large Cap Value Index), Utilities, and Oil & Gas, making up for it by dramatically overweighting Industrials.
It is no secret across the investment industry that Value has underperformed most other smart beta, i.e. factor strategies repeatedly over the past decade. It has even led numerous prominent investors and pundits to declare the “death of value investing.” And while the explosion of smart beta indexes (and the ETFs that track them) has generated impressive allocations to Value during the same time period, its dramatic underperformance risks a wholesale stampede of assets out of this perhaps most well-known, and longest-running, factor strategy. So what is to be done? Consider allocating to a product that tracks an index with a more nuanced methodology, like the Nasdaq US Contrarian Value Index. It is designed to avoid value traps and tailors its sector allocations to treat Financials separately from non-Financials, while excluding Utilities altogether. Furthermore, it bifurcates its methodology into bear-market and non-bear-market environments, during which a fundamentally-oriented strategy like Value may produce starkly different results.
For further analysis of value investing in the index space, please find our research piece here.
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