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Understanding ‘Value’ Factor in Smart Beta Investing

Posted on: 09.11.2016

Value is a primary factor in Smart Beta investing. The value investor takes a pragmatic approach to stock selection focusing on the fundamental of the company and their long-term ability to deliver profits and grow. The simple principle behind a value strategy is this: share price appreciation comes from purchasing stocks that are priced lower than the underlying value. In this post, we’ll look at how this factor influences the long-term growth of a Smart Beta ETF.

The best way to understand the factor is to examine the measurements it employs. One standard tool for measuring value is the price-to-book (P/B) ratio which represents the difference between the asking price of a share and its underlying value as determined by the assets of the company. A value investor seeks opportunities to limit downside risk through adherence to low P/B ratio securities. The price-to-earnings ratio (P/E) measures the disparity between the price and the earnings of a company’s stock. P/E represents the amount of time it will take for someone to earn back their investment. Finally, the dividend yield is a critical number to value investors because it promises payment even if growth is tepid.

What influence can a value tilted ETF have on long-term growth? The PowerShares FTSE RAFI US 1500 Small-Mid Portfolio (PRFZ) serves as a good example of a value tilt Smart Beta ETF. As the prospectus states, the fund selects companies, “based on the following four fundamental measures of size: book value, cash flow, sales, and dividends.” Therefore, the fund prefers companies that exhibit traditional hallmarks of value. This methodology is further evidenced by the lower P/E ratio (17.7) and lower P/B ratio (1.7) than the similar Russell 2000 index with a P/E of 18.6 and a P/B of 1.9. The performance of PRFZ underscores the effectiveness of a value strategy. Over short and long-term horizons the fund has outperformed its index counterpart.
Even compared to the broader market (S&P 500), this value play outperforms thereby giving investors an advantage over a more passive, market-cap weighting strategy. Over the past five years, PRFZ returned 90.33% while the S&P 500 returned 87.43%. Morningstar analyst Alex Bryan echoes the effectiveness of a value tilt strategy when he reports, “Over the long run, betting on value has paid off handsomely in nearly every market studied.” The stellar performance seen above can be replicated with another, similar value investing strategy. The PowerShares FTSE RAFI US 1000 Portfolio (PRF) has outperformed its underlying benchmark (Russell 1000 index) since inception.
A value approach offers the two benefits of (a) long-term growth and (b) limited downside risk. Finally, This below data sourced from the Kenneth R. French data library at Bloomberg posit a compelling picture for Smart Beta value tilt investors.

The value factor has beat the S&P 500 in annual return and sharpe ratio from 1962-2015.

The value factor has beat the S&P 500 in annual return and sharpe ratio from 1962-2015.

The historical performance of a Smart Beta value approach shows great promise. Over the extensive period ranging from 1963-2015, the value-focused Smart Beta style outperformed the S&P 500.

Corey Philip

Corey Philip is the founder of RealSmartBeta.com. His focus is on expanding investor knowledge of Smart Beta ETFs and quantitative investing. Learn more about Corey in the 'ABOUT' section of this website.

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