Michael Hunstad, PhD, Head of Quantitative Strategies, Northern Trust Asset Management, and Jordan Dekhayser, CFA, Head of Quantitative Strategist Team, Northern Trust Asset Management discuss the integration of value stocks into a portfolio.
Historically, value stocks have gone through cycles closely-linked to the business cycle, and they have done well during periods of economic recovery and rising interest rates. The low performance of value in the past few years, though, has concerned investors that value has departed from this cycle, staying instead at a depth where it might never again bounce back to outperform growth.
However, given the resurgence of value in the last quarter of 2020 and the first quarter of 2021, Hunstad asserts that value is still cyclical in nature. After having the worst performance on record for value compared to growth during the first three quarters of 2020, on the day after the Pfizer vaccine was announced, value had the biggest one day momentum reversal since 1992. Value is now outperforming growth by about 15%, and the fourth quarter of 2020 and first of 2021 represent the best performance for value versus growth dating all the way back to 1974.
From data tracking past business cycles and expansions, it’s clear that value does well in a high inflationary environment. Moreover, value tends to be at its best when the level of the VIX index (the Chicago Board Options Exchange’s CBOE Volatility Index, a measure of the stock market’s expectation of volatility) is above the median. So, value does well in periods of economic recovery and expansion, high inflation rates, and high volatility, all of which are expected as the global economy continues to reopen.
It’s important to note that different sectors perform very differently between inflation regimes. So, when considering equity exposure, the portfolio design really matters. Having a sector-neutral approach is the most effective way to insulate from inflation risk.
“We don’t believe that naively buying a slice of value stocks is the best way to position portfolios. Which value stocks are bought and how risk is controlled has a significant impact on outcomes,” says Dekhayser.
Combining value with quality and momentum can improve risk-adjusted returns and smooth cycles. “One of the tenets that we adhere to is that we like to form value portfolios that have a higher quality orientation as well as a higher momentum orientation, whether that’s in the large cap or small cap space,” says Hunstad. With higher quality and higher momentum, the risk-adjusted returns tend to be higher, and pricing or valuation of these portfolios tends to be relatively narrow.
Northern Trust Asset Management is a global investment management firm and leading provider of wealth and asset management for corporations, institutions, and individuals.
To learn more on this topic, watch the replay of of Northern Trust’s webcast: Is Value Investing Making a Comeback? Key topics include:
- Performance of factors in different macroeconomic, inflation, and interest rate environments
- Building a portfolio to reflect your macroeconomic views
- How combining Value with Quality and Momentum may result in higher returns and lower risk