Value-Focused Indexing

Everyone likes a deal; especially so in the current straitened times. But an investment approach based on a search for bargains is hardly new. For those with capital to deploy, value investing is perhaps the oldest strategy of all. Benjamin Graham and David Dodd wrote a seminal book on the subject in 1934, “Security Analysis”. In Graham’s opinion, a search for value was the only rational response to the Wall Street Crash that had nearly wiped him out five years earlier.

Many of the principles set out by Graham and Dodd—searching for intrinsic or fundamental value, identifying discounts to book value, investing with a margin of safety—have been widely copied. Warren Buffett, most notably, has built a multi-billion investment business by following what he called “the greatest book on investment ever written”.

But nothing is easy in the financial markets and there are plenty of pitfalls for the inexperienced. Signs of value, such as a high dividend yield or a discount to net balance sheet assets, may be a trap.

As one of the index firm contributors to the roundtable discussion on p14 of this magazine reminds us, the recent financial crisis gave us many textbook examples of notionally cheap stocks that kept getting cheaper—sometimes all the way to a zero share price.

How to create a dependable index-based, value investment strategy is therefore the highly topical theme of this issue of the Journal of Indexes Europe.

Robeco’s David Blitz sets out the pros and cons of so-called ‘smart beta’ indices in the first article of the issue. Smart beta indices may be set up more for simplicity and marketing appeal than investment efficiency, Blitz argues, while providing a useful categorisation of the most popular index approaches.

In our roundtable discussion, representatives of four leading index firms—FTSE, Research Affiliates, Russell and S&P Dow Jones—give a thorough overview of value indexing, including the similarities and differences between value approaches and other index strategies that depart from the standard, capitalisation-weighted method.

Patrick Burke d’Orey of MSCI investigates market “factors” in our third article. Common factors like value, growth, leverage, volatility, beta, non-linear size, earnings yield and dividend yield can explain a large part of equities’ risk and return, says d’Orey. Hence the continuing interest in replicating them cheaply, in an index format.

Société Générale’s Andrew Lapthorne looks into some of the paradoxes of value investing; why the highest dividend yield isn’t necessarily the best yield, and how his firm has designed an index to focus on sustainable equity income.

Finally, PGGM’s Mark Voermans gives an investor’s view of the rapidly developing equity “beta” business. What distinguishes a benchmark, an index and a strategy—words we commonly conflate? Read our interview with PGGM to find out how one of the largest European institutional investors sees the index landscape.

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