Rethinking Conventional Wisdom: Why NOT A Value Bias? by John West & Amie Ko – Research Affiliates
- Investors with both a long horizon and the courage to stay the course during market downturns, often still fail to harvest the structural excess return offered by value strategies whose robustness is supported by both data and theory.
- An inherent desire to conform to conventional wisdom combined with the classic owner–agent conflict may help explain why an equity bias is deemed conventional wisdom and a value bias is no longer seen as a reliable source of excess return.
- To manifest the benefit of all long-term sources of structural excess return—such as value—let’s challenge conventional wisdom and open a candid conversation between owners and agents.
An equity bias is deemed conventional wisdom in its ability to generate a reliable source of excess return, but a value bias no longer is. Statistics and theory reinforce the robustness of value strategies as a structural source of excess return for those with a long horizon and the staying power to hold through periods of adversity. Yet value investing is increasingly overlooked as a meaningful contributor in portfolio construction, and for many investors, is actually viewed as a risk to be diversified away.
We owe it to investors to question why all long-term sources of excess return are not treated equally in their portfolios and to take steps to correct this longstanding and entrenched bias against value in the conventional wisdom of the collective investment community. We examine a possible explanation for why a value bias does not figure more prominently in investors’ conventional wisdom.
Welcome to the classic blind taste test—The Pepsi Challenge. You approach a table with two white cups, one Pepsi and the other Coke. You take a sip of each and select your preference. With an upward sweep, the Pepsi rep sitting behind the table lifts the yellow blind, revealing two glass bottles. Drum roll, please. The results: most Americans preferred Pepsi! The outcome of “The Challenge” was hardly a surprise, and it was deemed one of Madison Avenue’s greatest ad campaigns.1
We’ve got our own “challenge” for you! We compare two anonymous sources of excess return and their long-term characteristics. Both represent robust sources of return premia2 very likely present in your portfolio today. We invite you to take a swig, compare the characteristics, and decide: Which do you prefer?
Lifting the Blind on Value
We won’t keep you in suspense. You’ve made your selection. It’s time to lift the blind!
Strategy A is a buy-and-hold investment in the S&P 500 Index, measured relative to 20-year US Treasuries.3 It represents the excess return of stocks versus bonds, the “go-to” source for leveraging the long-term investment horizon of pensions into meaningfully higher returns. The conventional wisdom is that stocks deliver higher long-term returns than bonds: on average, stocks are more volatile, creating the rational expectation that equity investors will be compensated with higher returns. This notion is further supported by the inherent risk premium for stocks over bonds because stockholders are behind bondholders in the first lien on a company’s resources in bankruptcy.
Strategy B is a value investing approach relative to the S&P 500 and is represented by the Fundamental Index™. Compared to a traditional value strategy, the Fundamental Index more robustly harnesses a “value premium” by using a rebalancing process, which generates a dynamic exposure to value.4 Over 50 years of empirical evidence show that long-term value investors outperform. Why is that? Those who subscribe to efficient markets argue that value investors extract a risk premium. Others contend investors have preferences broader than risk and return,5 making them prone to behavior that results in a value anomaly.
Although we don’t know which strategy you chose, we do know most investors make a much bigger bet on Strategy A than on Strategy B. In a typical pension plan, equities represent 60% of aggregate stock and bond holdings, whereas value constitutes less than 20% of all equity holdings.6
If the combined 15-year win rate7 of 82% and an average annualized excess return of 2.8% leads to a 2-to-1 allocation of stocks to bonds, why doesn’t the combination of a 96% win rate and an average annualized excess return of 2.1% over the same rolling 15-year span lead to a similar size bet on value? There seems to be a disconnect: Owners of capital should be demanding an overwhelming value bias8 in their portfolios.
What Puts the “Convention” in Conventional Wisdom?
Personal experience feeds into expectations, which in turn anchor the perception of what constitutes conventional wisdom. It then follows that the range of excess returns experienced by investment professionals over their careers must influence their investment decision making. For instance, a 65-year old who began a 40-year career in 1975 witnessed stocks soar by an annualized 7.8% net of inflation, beating the return of long bonds by 3.7% a year. That’s a heck of an equity return premium baked into her frame of reference.
When we repeat this exercise across current practitioners divided into five-year age cohorts from ages 25 to 70, the collective investment experience over the 1970–2015 period reveals that nearly 90% has lived through sustained periods of soaring stock prices. Collectively, these investors experienced stocks outperforming bonds by an average of 1.9% a year.9 Not surprisingly, the “stocks for the long run” mantra has dominated the conventional thinking around portfolio construction. The collective experience effectively “defaults” to a belief that this relationship should continue.
Indeed, all age cohorts, except for one, have experienced stocks outperforming bonds by at least 1.0% a year. The single cohort whose members over their careers have experienced stocks underperforming bonds is the now 35- to 40-year-old who began working at the peak of the tech bubble. From January 2000 to December 2015, equities delivered an annualized real return of 1.9%, underperforming long bonds by 2.9% a year. Understandably, this cohort may not be as enthusiastic about the stocks-for-the-long-run story.
During the same 45-year period ending 2015, investment practitioners’ personal experience with value investing has been far less buoyant, and the range of outcomes much more modest, than their experience with equities versus bonds. These investors have known value investing to deliver and average excess return of 1.1% a year, about half the annualized excess return generated by stocks over bonds. Although investors could not invest in the Fundamental Index—introduced only 12 years ago by Arnott, Hsu, and Moore (2005)—over the entire period, the principle of value investing has been well understood and practiced since Graham and Dodd (1934) first endorsed it. In the last decade, current practitioners have tangibly felt value investing’s severe disappointments alongside brilliant value-add generated by stocks versus bonds; not only are these recent events shared by nearly everyone in today’s investment community, they may also unconsciously and more heavily weigh on our memories and expectations, crowding out the wins experienced from value investing in earlier years.
Upon Closer Scrutiny…
Let’s look more closely at equities’ long-term outperformance. Particularly for the last 35 years, more than half of stocks’ real return came from rising valuations as dividend yields tumbled off their peak of 6.4% in