Growth Vs. Value: Death Of A Paradigm

September 25, 2009

Growth and value investing has been on life support for a long time now. Last year, someone finally pulled the plug.

A quick search of the ETF database will show you something quite telling—71 ETFs are dedicated to a slice of the market self-defined as either “growth” or “value.” That’s nearly 10 percent of the U.S. ETF market.

But honestly, why?

First, there’s a definitional issue. Russell (just to pick one index provider) defines their growth and value universe based on two characteristics: price-to-book and “projected growth” based on IBES (Institutional Brokers’ Estimate System) consensus estimates. This very distinction makes the indexer in me cringe. By taking the market and slicing it into buckets, and then picking one, investors are fundamentally picking stocks, and I still believe that rarely makes sense.

Let’s take a look under the hood at one family of growth and value: the iShares Russell 3000 series.

 

IWW vs. IWZ and IWW

 

This brutal chart looks at the Russell 3000 ETF, IWW, and compares it with the growth and value ETFs, IWZ and IWW, respectively. It’s a pretty compelling story for value investors, and indeed, it’s been a bad 10 years to be chasing earnings estimates—the value investor has made over 30 percent. The growth investor has lost nearly 40 percent, and was down over 50 percent earlier this year. Self-proclaimed value investors will undoubtedly say “duh” at this and note that the whole point of investing is to buy cheap and sell expensive, and that’s just what a value index is designed to do—select the cheaper stocks from a pool.

The problem, of course, is that Warren Buffett doesn’t run the index. The determination of what goes into which buckets is only made once a year in June (in the case of Russell), and stocks ping-pong between the two buckets based on where they happened to be trading at reconstitution. The top performers list for both the growth and value indexes over the past calendar year includes AIG, Citi and Martha Stewart. The decision to sell in one index and buy in the other was simply formulaic, and the timing entirely planned.

In short, it replaces the fallacy of picking the winner based on research, or a hunch, with picking the winner based on the calendar.

Further, there’s increasing evidence that the distinction between growth and value is far less relevant than it has been in years past. Consider the same chart over the last year:

 

IWW vs. IWZ and IWW

 

In this time period, the growth investor has ruled the day, losing just about 6 percent vs. the value investor’s 14.25 percent decline.

But perhaps more important for investors focused on actual portfolio construction instead of just stock picking, there’s evidence that the growth and value buckets could just as well be a random distribution.

 

IWZ and IWW correlation since inception

 

This chart plots the correlation between IWZ and IWW since inception, looking at rolling 30-day periods and daily returns.

Back during the end of the dot-com run-up and through the dismal 2001 period, there was a real difference between growth and value. It was possible to make the case that the two buckets had distinct performance characteristics: that splitting the universe based on IBES rank and price-to-book ratios created distinct portfolios where one zigged while the other zagged. Alas, what I see when I look at this chart is that the two buckets are now essentially identical, with correlations predictably in the 90s since the middle of the decade.

ETFs give us access to virtually every asset class in the world, from fine-grained equity sectors and themes to international bonds and currency. That the ETF industry has focused so much energy on the dinosaurs of growth and value seems unfortunate.

 

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