Measuring the Value Premium with Style ETFs

Do popular style-based exchange-traded funds (ETF) confirm the existence of a reliably exploitable value premium? To investigate, we compare the difference in returns (value minus growth) for each of the following three matched pairs of value-growth ETFs:

• iShares Russell 2000 (Smallcap) Growth Index (IWO)
• iShares Russell 2000 (Smallcap) Value Index (IWN)
• iShares Russell Midcap Growth Index (IWP)
• iShares Russell Midcap Value Index (IWS)
• iShares Russell 1000 (Largecap) Growth Index (IWF)
• iShares Russell 1000 (Largecap) Value Index (IWD)

Using monthly adjusted closing prices (incorporating dividends) for these ETFs during August 2001 (the earliest month available for IWP-IWS) through March 2011 (116 months), we find that:

The following table summarizes the average monthly value-minus-growth returns and standard deviations of these monthly return spreads by capitalization category across the entire sample period, along with average returns for two equal subperiods. Over the entire sample period, the average return spreads are positive for all three pairs. However, monthly variabilities are large compared to the averages, making conclusions elusive. The large difference in average returns, including sign reversal, between the first and second halves of the sample period undermines belief in a value premium persistently exploitable via style ETFs.

For a closer look at any trend in the value premium, we measure the value premium by month over the sample period.

The following chart plots monthly value-minus-growth returns by capitalization category across the entire sample period, along with associated linear best-fit trend lines. All three trend lines have negative slopes, suggesting that the value premium has dissipated over the sample period (or even reversed). It is possible that the introduction of style-based ETFs has made it easy for investors to pursue, and extinguish, any value-related abnormal returns.

Volatilities of value-minus-growth returns appear to rise during bear markets.

For a different perspective, we look at annual returns.

The final chart shows the value-minus-growth returns by capitalization category by year across the entire sample period. Value-minus-growth has four good years, three neutral years and two bad years. The average annual value premium is about 1% for all three capitalization categories. The wide swings in value-minus-growth returns makes forming any beliefs about the long-term value premium difficult.

In summary, evidence from simple tests with available data (about nine years) does not support a belief that investors can reliably capture a substantial value premium via style-based ETFs.

Cautions regarding findings include:

• The criteria for constructing/rebalancing the ETFs may not be suited to exploit the value premium efficiently. For example, as pointed out by a reader, it may be that capturing the value premium depends on exclusion of financial stocks as done in many academic studies but not done in forming these ETFs (financial stocks tend to concentrate in the value ETFs).
• The sample is short, and may be theoretically very short for reliable measurement of a value premium. For example, the premium may have an underlying multi-year dependency on some economic factor.

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