Investing in the Value 'Premium'

• By Mark Marex, Product Development Specialist, Nasdaq Global Information Services

Value was most famously identified as one of three factors by Fama & French in their original asset-pricing model (1994). The value “premium” refers to the excess return generated by investments in companies with lower price-to-book (P/B) ratios, in comparison to those with higher P/B ratios (i.e. growth stocks). The other two factors identified – Beta and Size – refer to the excess return attributable to a stock’s sensitivity to the overall market (i.e., high-beta stocks are net riskier investments and thus command a higher expected return than low-beta stocks) and its size, respectively (i.e. small-cap stocks are net riskier investments than large-cap stocks). Two additional factors were added to the pricing model in 2014 – Profitability and Investment.

Value investing was originally pioneered decades before Fama & French’s academic paper came out in 1994 by Benjamin Graham and Warren Buffett, among others. Over time, large-scale asset management businesses were built around the concept of value investing, and continue to operate at scale today, including Franklin Templeton (part-founded by Sir John Marks Templeton), Baupost Group (founded by Seth Klarman), and Gamco Investors (founded by Mario Gabelli). The substantial academic research (and real-world success) behind value investing acknowledges that periodic underperformance is possible – most notably during the late 1990s. Value’s most recent underperformance is longer-running and, in some ways, unprecedented:

Value as a strategy was historically only available to investors via high-fee, actively managed hedge funds and mutual funds – until the rise of passive indexing generally, and factor ETFs specifically. Today, retail and institutional investors alike can allocate capital to single factor-index-tracked products, including Value, Growth, Dividend/Yield, Size, Low Volatility, Momentum, and Quality. Since 2007, AUM tied to factor indexes has grown by more than 900% to almost $1T at the end of 2019.

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