Value Effect

Like small-company stocks, value stocks have outperformed historically. Value investing is often associated with legendary investor Benjamin Graham, co-author of Security Analysis, the classic investment tome first published in 1934. But the value effect received its most famous academic endorsement in a 1992 paper by finance professors Eugene F. Fama and Kenneth R. French, who defined value stocks as those shares that trade at a low price relative to their book value (“The Cross-Section of Expected Stock Returns,” Journal of Finance, Vol. XLVII, No. 2).

The following year, the two professors proposed their three-factor model (“Common Risk Factors in the Returns on Stocks and Bonds,” Journal of Financial Economics, Vol. 33, Issue 1). That model argued that a portfolio’s return could be largely explained by its exposure to the overall stock market, to small-cap stocks and to value stocks. Other research has found that higher-yielding assets, including stocks, bonds and other investments, have tended to generate superior long-run returns. Within the stock market, investors can capture both the yield effect and the value effect by purchasing higher-dividend stocks.

Value’s outperformance, which has occurred historically in both the U.S. and foreign markets, has been attributed to the greater risk involved. The companies involved often have shaky finances. That means there’s a danger they could get into serious difficulty, especially during an economic downturn, and shareholders might lose everything.

Still, not everybody has been convinced by the risk argument. Before academics documented value’s outperformance and attributed it to risk, these stocks were typically viewed as less risky than growth stocks, because their share prices were less volatile. An alternative explanation: It could be that the value effect is a behavioral phenomenon. Perhaps investors become overly enamored of growth companies and pay too much for their shares, while mistakenly shunning value companies, where growth prospects often appear grim. If that’s the case, it could be that the value effect will disappear as investors adjust their behavior. In Wall Street parlance, there’s a risk that value stocks will become a “crowded trade,” with too much money pouring into the sector, thus driving down future returns.

Intrigued by the value effect? There are plenty of index funds available that allow you to tap into U.S. large-cap and small-cap value stocks. Vanguard Group offers four value-tilted index mutual funds that are available directly to investors, while Dimensional Fund Advisors offers a variety of value funds through its network of independent advisors. There are also many ETFs available, including those from BlackRock’s iShares unit, State Street’s SPDR ETFs and Vanguard.

In addition, you might tilt your foreign stocks toward value. A new option: In 2016, Vanguard Group launched the Vanguard International High Dividend Yield Index Fund as both a mutual fund and an ETF. The fund has roughly a fifth of its portfolio invested in emerging markets.

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