measuring equity performance using style indices: growth vs. value

value vs. growth

It’s been my strong impression that in the US market growth stocks have outperformed value stocks this year.  I get that impression, among other things, from looking at my own portfolio (remember, I’m a growth investor).  This wouldn’t be surprising, since in a typical business cycle recovery value stocks outperform strongly in the first year.  But as pent-up demand is gradually satisfied and the economy slows a bit, growth stocks typically take over market leadership.


But I know I look mostly at growth stocks.  So I thought I’d check the IWD and IWF ETFs.  These are securities that track the Russell large-cap value and growth stock indices, respectively.  They show a neck-and-neck battle until the past couple of months, when the growth index pulls out in front.

Indices like these are the best we have.  And from a practical money management perspective, if a client were to hire me as a money manager and specify the Russell 1000 Growth Index as my benchmark, it would be simple enough to construct a portfolio whose under- and overweights would be geared to that index.

how good are style indices?

But are such indices really good representations of the relative performance of growth and value stocks?   Not so much.  The reason has to do with the academic tilt to their construction.  To be honest, I don’t have a better solution.  And as you’ll see in a moment, the way the growth index is composed may give a manager benchmarked against that index a slight performance advantage.  So I’m sure these style indices are here to stay.  You just have to remember that the growth index in particular has some drawbacks.

Here’s what I mean.

The idea of style indices has its genesis in the reasonable question, posed by academics, as to whether either a value discipline or a growth investing discipline has an inherent advantage over the other.  Their method was to divide a stock index with broad market coverage, like the S&P 500 or the Russell 1000 into value and growth components and then study the relative performance of the two.

constructing a style index

They proceeded as follows:

1.  They defined value stocks, reasonably, as those with some combination of low price to book (or net asset value), low price to cash flow, and low price to earnings.

2.  Using various weightings of these three factors, or other similar ones, they constructed a ranking of index constituents that ordered them from being the most value-like (scoring the best on the value stock variables) to the least.

3.  Using this list, they (usually) took the half exhibiting the best value characteristics and called it the Value sub-index.  They called the other half of the list the Growth sub-index.

4.  They compared the performance of the two sub-indices.

Looking at the relative performance of the sub-indices over time is itself interesting:  until the Nineties, relative outperformance of either style is short-lived.  Starting in the recovery of 1992, however, Growth and Value each have multi-year periods of significant outperformance.

The overall academic conclusion, supported by the sub-indices, is that Value trumps Growth over long periods of time.

the error in logic

The academics make two assumptions that have no factual, or logical for that matter, support.

–They assume that every stock can be characterized either as growth or value.  This allows them to define growth as being what’s left over when value stocks are separated out.  hey don’t consider that there may be a set of “clunkers,” or stocks no one in his right mind would touch (even though there’s research showing that bad-performing stocks persist in underperformance far longer than good stocks in their outperformance).  They all get tossed into the growth pile.

–They assume that the growth stock universe and the value stock universe are mutually exclusive–that growth investors somehow refuse to buy fast-growing companies unless their price-earnings multiples were already high.  That would be crazy.  At the beginning of this year, for example, AAPL–a classic growth stock–was trading at 10x earnings, with no debt and cash making up a quarter of its market value.  Has AAPL been a growth stock for the past five years?  Yes.  Has it been a value stock, too?  Yes, again.  But which sub-index is it in?  Depending on how a particular style index is constructed, it could be either.

Of these two errors, I think the first is the more serious.  My suspicion is that the supposed underperformance of a Growth sub-index is because of the presence of clunkers.

Why don’t growth investors make more of a fuss over their investing style being maligned?  I think it’s the same reason why professional investors don’t make a fuss about many of the other crazy, erroneous things taught about investing in business schools.  Why invite more competition?





Leave a Reply