Is a Growth-to-Value Leadership Change Underway?

Note: This article appears on the Strategist Channel

By Robert Leggett, CFA

In our process, we consistently analyze leadership trends of Large Cap Value vs Growth indexes. While our focus in this piece is on the iShares S&P 500 Value Index (IVE) vs the iShares S&P 500 Growth Index (IVW), the results are similar for investors who choose to utilize Russell 1000 indexes (Value – IWD and Growth – IWF) instead.

We will discuss three important observations which lead to critical questions for investors:

  • Large Cap Value Index vs Growth Index relative performance can be significant to portfolio returns. One lesson we draw from history is that the portfolio default overweight should be to Value indexes.
  • Value vs Growth leadership often runs in long cycles. Through the end of 2015, Growth had outperformed Value by an astounding 3.08% per year for the trailing 5 years. Growth won the annual performance derby 4 of the 5 years and 7 of the past 9 years.
  • Leadership trends have shifted often over time. Can we identify markers that may indicate an impending reversal of Value vs Growth leadership?

Why investors should focus on Value vs Growth ETFs

Many investors may choose to simply invest in the S&P500 alone, instead of gaining exposure to the S&P 500 stocks through a combination of an S&P Value and S&P Growth index.   Due to our extensive investment process, we find there is benefit to holding exposure to the underlying Growth and Value indices for many of our portfolios.  By holding the components, as opposed to the aggregate, we are able to add value by using two levers instead of one.

There are many ETFs available that allow investors and traders to establish positions in possible market leaders and against projected market laggards. Some options in the ETF landscape include leveraged ETFs such as the Direxion Daily Bull and Bear 3x ETFs (SPXL and SPXS), but also arcane sub-indexes such as iShares Exponential Technologies (XT). We prefer to focus instead on areas where we feel long term value can be added.  This allows us to identify ETFs that can materially enhance longer term returns, without forcing us to take on unacceptable risks.

Related: Uncle Sam Wants You to Have High Portfolio Turnover

We do not need to limit the TOPS portfolios to simply using the broadest indexes, such as the S&P 500, because the next level of specialization is simply dividing the index into its Growth and Value components. Our research suggests there may be an advantage to overweighting portfolios to Value over time. Is that because “cheaper” stocks always do better than “faster earnings growth” stocks? Well, no. The key to this performance record may be revealed in the methodology used by S&P to build the indexes.

Visiting the “sausage factory” gives us some worthwhile insights

There is an old adage that “Laws are like sausages, it is better not to see them made” and the same may be true for equity indexes. However, we believe it is important to understand how Standard & Poor’s manufactures its S&P 500 Value and Growth indexes.

In the first step, S&P uses a short list of Value and Growth characteristics to rank every stock in the S&P 500.  They then assign 33% of the S&P 500 companies to the S&P Value Index Value and 33% to the S&P Growth. Next, the remaining 34% is assigned to both V and G, with each stock’s capitalization split according to whether it ranks higher in the V rankings or the G rankings. It is important to understand that this results in indices created on relative rankings rather than a “pure” focus on absolute characteristics.

The attributes used for Value are not surprising: ratios of book value to price, earnings to price and sales to price. On the other hand, many “growth” managers would not necessarily rely on the measures used to select Growth equities: sales growth, the ratio of earnings change to price, and price momentum. You may have noticed that actual or expected EPS growth is not on the Growth list.

The net effect of this is the S&P Value vs Growth index methodology boils down to:

1) Lower valued vs higher valued

2) Lower price-momentum vs higher price-momentum.