The trouble with value is the trouble with agents
If you want to understand why value strategies have trouble attracting inflows, look not at investors but at the people they hire.
Value investing, it must be said, has had a terrible run. Despite long-term evidence that seeking out undervalued stocks works, the last few years have not been pretty. Large-cap value stocks have underperformed growth stocks and the S&P 500 for seven of the past nine full years.
That may help explain why only 20% of equities held by public-sector pension plans are value stocks.
Take a longer view and use a value- and cap-weighted index and the merits of value come into focus. The S&P 500 has offered 2.9% annualized excess return above 20-year Treasuries from 1962–20l5. That’s against a 1.8% annualized excess return for a Research Associates value index, but with about a quarter of the risk and more periods of outperformance over rolling three- and 15-year periods.
Why, in other words, do investors show a strong bias towards stocks but not towards value?
Part of the trouble, both with attracting funds to value approaches, and with sticking with them during the sometimes long periods of underperformance, may be traceable to the inevitable mismatch between what is best for the owner of the money and what is best for the manager hired to advise or execute a strategy.
“Principal–agent conflicts arise from contradictory motivations between the owner (the principal) and the person delegated to act on behalf of the owner (the agent),” John West and Amie Ko of Research Affiliates write in a note to clients.
“The time horizon for owners can span decades. The time horizon for agents is the span over which their own performance is judged - years or even shorter time periods. As such, agents face a powerful incentive to minimize short-term drawdowns relative to peers and benchmarks.”
In other words, advisors and fund managers find it hard to advocate for value, or execute it, because it carries higher career risk, the risk that they will lose assets or their jobs. It is one thing to stick with a value strategy if you are Warren Buffett. Quite another if you are a typical pension fund advisor or fund manager being judged on your latest three-year results.
Momentum is a social and economic force
Much of this thinking accords with that of Paul Woolley, a veteran IMF official and fund manager, and Dimitri Vayanos, of the London School of Economics, who have argued that the very activity of benchmarking puts fund managers in a position where they are all too likely to follow the crowd.
A fund manager who is judged by a benchmark has an inbuilt reason to buy that which has just gone up in value. If a fund manager is underweight Amazon and Amazon is outperforming, the pressure mounts to buy in or look bad when mandate review rolls around. That pressure often leads to cynical buys of stock not based on fundamentals. Those defensive, or self-interested, stock purchases extend the momentum cycle. Amazingly, that’s despite risky stocks historically underperforming less volatile ones.
Value, Woolley and Vayanos assert, can work, but requires trust and a long horizon by savers.
The issue may also be partly one of conditioning, according to West and Ko of Research Affiliates. Over the past 45 years most generations of asset managers have experienced long periods of strong outperformance of stocks against bonds, reinforcing convention wisdom, but less good results for value.
“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,” West and Ko write.
The rise of passive investment, which now accounts for 40% of the money invested in US stocks, has probably raised pressure on managers to stick with convention and emphasize the short term.
After all, if you are working in a declining industry, which active investment shows many signs of being, you might want to emphasize remaining employed over creating long-term returns.
Ultimately, it will be up to investors to bring their agents to heel.
(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at firstname.lastname@example.org)