Returns from passive index funds in the medium term are unlikely to excite.’ (Piet Viljoen)
Over the last 12 months we’ve seen a shift in factors that have driven investment returns. Although returns from value investing seem to have recovered, there is evidence to suggest this recovery is still in its early stages. This shift has important implications for where investors should expect to find returns over the next seven to ten years.
While data proves that value investing outperforms growth investing over time, returns from growth and passive index investing have strongly outperformed value since the Global Financial Crisis. Given the length and depth of value’s recent under-performance, the size and speed of the recovery has been remarkable.
This recent experience counters the misperception that value investing only comes to the fore during a market collapse. In this instance, value’s out-performance has come while the MSCI World Index continued its rise, while the JSE/FTSE All Share Index was in essence flat.
Simple mean reversion would suggest that if the relationship between returns from value and growth investing reverts to its long-term trend, there is still considerable scope for out-performance. However, there are other fundamental factors to consider.
One of the primary drivers of growth’s strong performance has been the artificial suppression of global interest rates to reflate asset prices after the financial crisis. With interest rates close to zero or even negative, this crucial support no longer applies – interest rates simply can’t fall meaningfully from current levels.
With interest rates and inflation likely to rise going forwards, this bodes well for value stocks which tend to perform well in rising interest rate environments. This, combined with the extent of the dislocation between the valuations of growth and value stocks, provides a strong tailwind which we believe will continue to favour value as an investment style going forward.
The flow of funds into passive index trackers has supported the momentum in the market and while investors have done well to follow a passive strategy for the last few years, returns from current levels are likely to be more modest.
Passive vehicles buy into the highest priced shares since these make up the biggest part of indexes. They also neglect under priced value shares, which become an increasingly smaller component of the indexes, leaving passive portfolios strongly biased towards expensive growth stocks at this point in the market.
Investors have tended to prefer the investment style that has historically performed best up to that point, and allocate funds accordingly but end up with disappointing returns thereafter as a result. For example, fund flows into hedge funds – the most actively traded investment vehicles – peaked shortly before hedge funds started to under-perform broader markets.
Current fund flows into passive investment vehicles are stronger than ever. We would argue that at current market levels, returns from passive index funds in the medium term are unlikely to excite.
RECM’s performance over the last few years has directionally followed other value investment styles –in terms of the under-performance prior to 2016 and the strong recovery in performance thereafter. The fundamental reasons that value investing should and does outperform over the long term remain in place. Value investing exploits the foibles of human nature which create the greatest inefficiencies in the market, and nothing about those foibles has changed. RECM’s funds have performed strongly over the past year and we believe that the recovery still has a long way to go.