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.
The Virtues Of ‘Packeting’
CRSP may have gotten somewhat wise to this, however, as it’s introduced the concept of “packeting.”
To quote the methodology document:
“Once a security crosses through the band between its current style placement and the other one, 50 percent of its holdings are moved. If the security stays beyond the threshold in the following ranking period, the remaining 50 percent will be moved. Therefore, a security may be partially held in both a value and a growth index.”
In other words, as the security changes style, at least 50 percent of the position will be held for another quarter. Assuming that crossing from value to growth implies at least some appreciation in value, then at least we hold on for another quarter.
While I think packeting is a step in the right direction, I believe it still falls short.
Value Extraction Re-examined
If we believe the value premium, broadly, takes at least a year to mature, then we should hold that security for at least a year. To do this, we would employ “tranching.”
Quarterly tranching would be implemented by using 25 percent of your portfolio to buy each quarter’s vintage and then rolling over that vintage every year. So today your portfolio would comprise the March 2014, June 2014, September 2014 and December 2014 value portfolio vintages.
At the end of March, we’d roll the March 2014 vintage portfolio into a new March 2015 vintage. This methodology gives us the benefit of diversifying across vintages without sacrificing the need to allow the vintage to mature.
This tranching technique is actually something we employ at Newfound in our tactical portfolios, but over a shorter time horizon.
We believe that the momentum premium we are tracking takes about one month to mature. So, while we reconstitute our portfolios weekly, the reconstitution merely rolls one of the four weekly vintages over, allowing each vintage a full month to mature.
In Search Of New Ways To Reconstitute
Unfortunately, there’s not a single index provider or ETF issuer I am aware of that incorporates the tranching concept in reconstitution, though there are other ETF strategists that do.
Nevertheless, in some cases, we may actually be able to proxy this methodology on our own.
For example, the iShares S&P 500 Value ETF (IVE | A-91) tracks the S&P 500 Value Index, which also reconstitutes on an annual basis, but does so in December. While the underlying S&P-based value definition differs from Russell’s, using IWD and IVE in tandem may allow us to diversify not only our methodology risk, but also our vintage risk.
Reconstitution is not a sexy topic by any means, but it can have a massive implication for how your portfolio performs.
While these examples have been limited to value portfolios, reconstitution affects almost all strategic, tactical and fundamentally based portfolios that are available today.
My advice: Don’t overlook reconstitution in your due diligence process.
At the time this article was written, the author’s firm owned shares of IWD on behalf of clients.
Newfound Research LLC is a Boston-based quantitative asset management firm focused on rules-based, outcome-oriented investment strategies. Newfound specializes in tactical asset allocation and risk management solutions. Founded in August 2008, Newfound offers a full suite of tactical ETF managed portfolios covering global equity, U.S. small-cap equity, multi-asset income, fixed-income and liquid alternative asset classes. For more information about Newfound Research LLC, call us at 617-531-9773, visit us at www.thinknewfound.comor email us at [email protected]. For a list of relevant disclosures, click here.