The Wrong Way to Pick Value Investing Funds
US News laundry lists their top 10 “Value Investing Funds,” or Value Investing ETFs, in their recent article:
The criteria (and weighting) for selecting so-called “Value” ETFs are outlined below:
- Expense Ratio (30%)
- Tracking Error (30%)
- Bid/Ask Ratio (20%)
- Diversification (20%)
Assessing the Criteria
The criteria seem reasonable enough–at the outset. For example, expense ratios are clearly important, and all else equal, lower is better. No qualms here.
But the other criteria don’t make any sense in the context of active investing, especially value-investing!
- Tracking Error — the volatility of the spread in returns between a benchmark and a strategy.
- Minimizing tracking error is akin to maximizing “diworsification.“
- Non-closet indexing funds are penalized?
- Bid/Ask Ratio — measure for how much the ask exceeds the bid; a measure of liquidity
- ETF liquidity is primarily driven by the liquidity of the underlying securities the ETF holds.
- So distress security funds–sometimes referred to as “value” funds–are penalized?
- A phone call to an ETF trading desk that will offer you $50,000,000 liquidity at a 1 penny spread doesn’t matter?
- Diversification — Typically measured by the number of securities held in a portfolio and/or exposures to various sectors/industries.
- Charlie Munger, a preeminent value-investor speaking alongside Warren Buffett at 2004 Berkshire Hathaway Annual Meeting is quoted as saying, “The idea of excessive diversification is madness…almost all good investments will involve relatively low diversification.”
- Nondiversified value portfolios are penalized?
As I’ve pointed out, it is unclear that tracking error, bid/ask ratios, and diversification should be criteria for selecting a value investing fund or etf.
Just how much Value to these Value Funds have?
To assess how much “value” is in these value ETFs, we can run a simple factor analysis. To keep things easy we’ll focus on the classic 3-factor Fama-French analysis. This analysis focuses on assessing a strategy’s exposure to the broad market (RM-rf), small-cap stocks (SMB), and value-stocks (HML).
First, a benchmark for value, or HML exposure, from Ken French’s website:
- VAL_10 = Top Decile market-weighted value portfolio (Data)
And the associated factor model analysis. Note the HML factor loading of ~.9 from 1/2011 through 12/2014.
I ran some quick stats in PortfolioVisualizer.com to see just how much “value” these so-called value investing etfs identified by US News actually had.
Not much value to be had. But plenty of closet-indexing.
HML betas are all roughly .2 to .3, a far cry from the basic VAL 10 portfolio.
Avoid US News when assessing which “value funds” are the best fit for your portfolio. (Duh!)
Unless, of course, you value low-tracking error passive market exposures wrapped in a more expensive wrapper entitled “value fund.”
Note: This site provides no information on our value investing ETFs or our momentum investing ETFs. Please refer to this site.
Join thousands of other readers and subscribe to our blog.
Please remember that past performance is not an indicator of future results. Please read our full disclaimer. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. This material has been provided to you solely for information and educational purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and Alpha Architect to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Alpha Architect.