This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Corey Hoffstein, co-founder and chief investment strategist for Boston-based Newfound Research LLC.
Each major index provider and ETF issuer has its own spin on what a “value” portfolio is.
Some use simple rankings based on price-to-book (P/B) ratios, whereas others use more complicated multifactor models. Some weight portfolios based on market capitalizations, while others weight based on valuation scores.
Some see “growth” and “value” as purely unique sets, whereas others see the lines between them as blurred. When evaluating the methodology of a value portfolio, these are often the points most commonly considered.
But nobody ever seems to talk about reconstitution.
Reconstitution is an important part of index and portfolio management. To quote the Russell index methodology,
“[a]nnual reconstitution is the process by which all Russell Indexes are completely rebuilt. Reconstitution is a vital part of the creation of a benchmark that accurately represents a particular market segment. Companies may get bigger or smaller over time, or periodically undergo changes in their style characteristics. Reconstitution ensures that companies continue to be correctly represented in the appropriate Russell Indexes.”
Let’s examine the iShares Russell 1000 Value ETF (IWD | A-87), which tracks the Russell 1000 Value Index. According to the index’s construction methodology, the index is entirely reconstituted on an annual basis.
This reconstitution process begins with ranking by market capitalization at the end of May of each year, and actual index reconstitution occurs on the last Friday in June.
Why June? Who knows? But as I see it, you aren’t actually getting a value portfolio: You’re getting a “June vintage” value portfolio.
I’m stealing a term from private equity here.
The “vintage year” generally refers to the fact that the market cycle can have a large impact on explaining the returns for private equity investments. Whether the year occurs during a peak or a bottom of a market cycle will define both the opportunity set for investments and expectations for them. Private equity investors, then, often try to diversify their vintage by spreading their capital investments across many years.
The way Russell has defined the index reconstitution means that investors will only get a portfolio of stocks that happen to be exhibiting value characteristics in late May. A sector sold off heavily in December and recovered by June? Sorry, IWD holders—you didn’t get a taste of that.
On the other hand, if a sector sold off heavily in December and appeared to be a value play until fundamental reporting caught up, then IWD likely avoided that falling knife. So vintage risk can both hurt and help.
But the reconstitution decision goes beyond just vintage risk.
Consider the Vanguard Value ETF (VTV | A-100), which follows the CRSP US Large Cap Value Index. The methodology guide tells us that the index is reconstituted on a quarterly basis, with eligibility updated on the first Friday of March, June, September and December, and reconstitution two weeks later.
While an increased reconstitution frequency may relieve some of the vintage issues previously highlighted, it potentially comes with its own problems, ignoring increased turnover and trading. Moreover, a full quarterly reconstitution may prevent the value premium from “maturing.”
In other words, we may continually cycle into the cheapest equities, buying and then subsequently selling them before they have fully recovered. This design means we’re never actually harvesting the full excess return potential from their eventually appreciation, but instead always holding a portfolio of the presently cheapest stocks.