Research suggests that the current economic backdrop and recent market turbulence means value ETFs are potentially primed to “spring back”.
Global equity markets suffered a significant market correction in October. The MSCI World Index, consisting of stocks from 23 developed market countries, fell 7.3% during the month, while the MSCI Emerging Markets Index tumbled by 8.7%.
The S&P 500 was down around 6.8% over the same period.
As has historically been the case during prior periods of market turbulence, growth stocks experienced the sharpest losses. Indeed, the Russell 1000 Growth Index shed 8.9% in October, which is approximately two standard deviations away from its mean monthly return.
From a sector standpoint, tech stocks were particularly hard hit, enduring their largest fall since 2008. The tech-heavy Nasdaq crashed 9.2% during the month, led by large losses such as Alphabet’s 9.7% and Amazon’s eye-watering 20% slump.
By contrast, US consumer staples and utilities sectors – traditional value plays – posted positive returns in October, the only sectors to do so.
Stage set for value?
While October saw a significant sell-off in the growth factor, the low volatility and value factors posted positive performance due to their current negative correlation with growth. This was reflected in flow patterns within the US-listed ETF universe. ETFs providing exposure to US growth strategies saw net outflows of $841 million during the month while their value counterparts attracted over $2.5 billion in new capital during the same period, according to data from SSGA.
In fact, investors have been favouring US value stocks over growth stocks since June 2018, adding a tailwind to the segment’s performance. SSGA believes the strength of these flows is likely to continue due to an economic environment conducive to value outperforming. It points to MSCI research that highlights the value factor has tended to outperform in moderate growth environments.
The firm’s own forecasts include a growth rate for the US economy of 2.9% in 2018 and 2.6% in 2019.
SSGA also notes that “low interest rates have favoured growth stocks because growth stocks have a greater proportion of their cash flows occurring in the distant future, as they are assumed to continue growing at a higher rate over time. As interest rates normalise, it should therefore favour value stocks more.”
Another reason why value may be set to outperform is that the factor has been in the doldrums for some time, suffering more than usual during this previous cycle.
Lyxor provides some insight into how the value factor got so cheap, trading at recession-like levels despite overall equity markets performing well.
The issuer notes that the US yield curve has flattened lately, implying an increased risk of recession. And rising rates are pressurising corporate balance sheets, with the firms with the worst balance sheets tending to be in the value universe.
Lyxor points to trade tensions, and the way the very low interest rate environment in Europe and Japan has eroded financials’ (another typical value sector) margins, as additional headwinds.
Recent flow patterns however suggest that value investors seem to have capitulated. According to Chanchal Samadder, Head of Equity Product Development at Lyxor, that might just be the opportunity you need to invest.
According to Samadder, “the value factor is like a compressed spring. The more you pile on the problems, the worse it performs and the cheaper it becomes. But in doing so, the greater the potential for it to spring back if any of the problems are resolved, or just become less acute.
“And that’s how it looks today. Equity valuations may be stretched in developed equity markets, but the value factor has only ever been as cheap as it is today at times of crisis. Valuation is the key driver of the style’s returns so the catalyst is clear.”
Of course, investing in the value factor does not come risk free. The main worry would be that economic conditions worsen significantly, which would be bearish for all stocks. However, both SSGA and Lyxor believe the macroeconomic backdrop is more likely to improve which could precipitate a short, sharp value rally in the space of a few months.
SSGA and Lyxor offer a number of ETFs in the value space, across US, European and global exposures.
For US value, investors could consider the SPDR MSCI USA Value UCITS ETF (USVL LN). This fund tracks the MSCI USA Value Exposure Select Index which includes 125 large- or mid-cap stocks with higher value exposure while screening out firms with poor quality characteristics. Constituents are weighted through a combination of free float-adjusted market capitalization and combined value-quality scores. The fund comes with a total expense ratio (TER) of 0.25%.
Alternatively, Lyxor offers the Lyxor Russell 1000 Value UCITS ETF (RUSV LN) which tracks the Russell 1000 Value Index. The index selects the companies from the US large-cap Russell 1000 Index that have lower price-to-book ratios and expected growth values. There are currently 726 constituents within the index which are weighted to enhance exposure to the value factor. The fund comes with a TER of 0.19%.
For small-caps, there is the SPDR MSCI USA Small Cap Value Weighted UCITS ETF (USSC LN) (TER 0.30%), a value-weighted strategy based on smaller companies.
Investors looking to target Europe could consider the SPDR MSCI Europe Value UCITS ETF (EVAL LN), which tracks the MSCI Europe Value Exposure Select Index. This index follows a similar methodology to its US counterpart to select 125 value-quality stocks from developed market countries in Europe. Its TER is also 0.25%.
And for small-cap exposure, the SPDR MSCI Europe Small Cap Value Weighted UCITS ETF (EUSV LN) (TER 0.30%).
For investors with a global outlook, the Lyxor SG Global Value Beta UCITS ETF (SGVB LN) could be a useful option. This fund tracks a proprietary index created by the indexing division at Lyxor’s parent company Societe Generale. It selects 200 of the most undervalued developed market stocks based on five fundamental metrics. Stocks are equally weighted on a quarterly basis. The fund’s TER is 0.40%.