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Why Some Value Strategies Struggle When Value Stocks Surge
Not all value strategies have benefited equally during value stocks’ recent outperformance versus growth stocks. Head of Quantitative Strategies Michael Hunstad, Ph.D. examines why some strategies have underperformed recently and which value strategies may deliver better outcomes.
Over the past year, value stocks have surged about 25% ahead of growth stocks, which have been sunk by rising interest rates, and the prospects for a slower economy. However, not all value strategies benefited equally. While we feel value will continue to be attractive, investors must exercise judgment in choosing well-designed value strategies. Let's take a closer look.
We've noticed an interesting trend regarding tracking error in value strategies. As a reminder, a large tracking error means an investment manager's portfolio diverts significantly from a broad benchmark, indicating a high degree of active investing. Intuitively, investors might think that a high tracking error, possibly indicating more pure or deep value investing, means stronger relative performance when value broadly outperforms.
Historically dialing up tracking error in value hasn't necessarily improved performance. Indeed, over the last year, we've seen an inverse relationship between tracking error and excess return among value managers. This counterintuitive outcome highlights the challenges of security and sector selection among value stocks. In May, value achieved the highest returns in the tech sector but deep value strategies with high tracking errors significantly underweighted tech, reducing relative performance. Chronic sector biases aimed at increasing active risk have generally detracted from value returns over the last 12 months.
With stock selection, failure to account for increasing leverage among value stocks has also been a drag on performance. Despite low multiples, many value companies have taken advantage of the low interest rate environment and increased their debt-to-equity ratio. Today, value stocks are more rate-sensitive than ever before, with rising rates significantly impacting the returns of the most levered names.
Many concentrated high tracking error portfolios haven't been able to diversify this rate exposure and have been negatively impacted. Given the current macroeconomic climate, we feel value has a long runway. However, judicious security selection and portfolio construction will likely be the key to success in value investing going forward, just as it has been over the last year. Well-diversified, sector-neutral strategies are some of the best ways to harness the value premium.