Value and growth index funds have traditionally acted as targeted investment options for many investors. However, these traditional style indices may not offer the same benefits as factor-based, smart beta exchange traded funds.
“Traditional style indexes may not offer pure exposure to value and growth stocks because they often must account for an entire stock universe,” Fidelity Investment strategists, led by Darby Nielson, said in a research note.
The Fidelity team explained that the style indices that many are acquainted with were designed to cover an entire universe of stocks across the value/growth spectrum and classify them as one or the other, and even both in some cases. These traditional indices may be comprised of inexpensive stocks that appear to be growing quickly, or stocks within a value style index may not truly be inexpensive but have weak earnings.
For example, Apple (NasdaqGS: AAPL), which is traditionally defined as a growth stock, makes up about 5.5% of the widely observed Russell 1000 Growth Index and still make up 0.48% of the Russell 1000 Value Index. These traditional style indices would have a large tilt toward their specific growth or value styles, but they may still include some residual exposure to the other style.
“It is better for investors to rethink the value definition and how you get value exposure,” Matthew Horne, Director of Sector and ETF Investment Strategy at Fidelity Investments, said in a call with ETF Trends.
For example, a factor-based value strategy would specifically screen for value by identifying companies trading at low price-to-earnings ratios and exclude those aren’t. Through a targeted definition of value to capture stocks, investors will hone in on a the segment of the market that is truly trading at a discount. It is also important for investors to understand a factor-based indexing methodology since various providers would have varying definitions, including earnings, book-to-price, sales or cash flow, which may affect performance.