What drives value tilt portfolios overperformance

1. Part of State Street’s Vision thought leadership series
SSgA CAPITAL INSIGHTS THE EXCHANGE
What Drives Value Tilt
Portfolios’ Overperformance?
Markowitz and Sharpe’s Modern Portfolio Theory has notably
focused on the concept of efficient portfolios and the Capital Asset
Pricing Model, where any additional return from a market-cap
portfolio has an additional cost in terms of risk. Subsequent work
by Fama and French has since identified two further risk premia
that appear to provide additional structural return: the small cap
and the value premia.
Whereas the small-cap premium may be explained in terms
of beneficial low liquidity and high cost, the value premium
although apparently consistent, can be more difficult to
explain. The value premium can be captured through several
methodologies. Several academic explanations of value’s
overperformance, with both rational and irrational bases,
have been proposed. It does seem clear, however, that value
overperformance can be linked to
market risk.
Construction
At a basic level, value indexes tilt the market-cap portfolio
towards low valuation stocks. Low valuation stocks are defined
as having a low price relative to any fundamental accounting
figure. Historically, the typical figure used has been the
price-to-book ratio. This ratio was used to create one of the
first value and growth indexes.
Dividends may also be considered, and the index then becomes
a low price-to-dividend index, also known as a high dividend
yield index. Other common fundamental metrics are earnings,
sales or cash flow.
The weighting scheme can be a tilt applied to the market-cap
portfolio, or to an equal-weighted portfolio or it may be
constructed from an optimization. The universe can be the full
initial universe, half of it, in case of a value and growth index,
or a lower proportion, in the case of a high dividend yield index.
Although the basic idea is simple, there is now a proliferation of
value indexes in the market.
The Value Tilt Portfolio
Consider a Value Tilt portfolio that can be constructed by
splitting the investable universe into 20 market capitalization
buckets of 5% each, ranked by valuation. Each bucket is
then tilted according to the bucket valuation versus the total
average valuation. The valuation is computed using the 5-year
exponential average of 5 factors: sales, earnings, dividends,
book value and cash flow. This Value Tilt Portfolio is readjusted
once a year.
by
Frederic Jamet
Head of Investments, SSgA France

2. SSgA CAPITAL INSIGHTS | VALUE TILT PORTFOLIO
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Overview of Available Value Indexes
Three of the Most Well-known Value indexes
FTSE RAFI Index Series Fundamentally-weighted index series developed in partnership with Research Affiliates LLC;
securities are ranked by the following four factors: dividends, cash flow, sales and book value.
MSCI Value Weighted Indices Alternatively-weighted indices where constituents are weighted by valuation factors including: sales,
earnings, cash earnings and book value; available for a number of MSCI Global Indices.
Russell Fundamental Indices Fundamentally-weighted index series developed in partnership with Research Affiliates LLC;
securities are ranked by the following three factors: adjusted sales, operating cash flow and
dividends plus buybacks.
Different Versions Also Available:
FTSE ActiveBeta Index Series Alternatively-weighted indices that were developed in partnership with Westpeak Global Advisors and
are constructed by ranking securities by value and momentum factors; index universes are derived
from FTSE’s All-World Index Series.
FTSE GWA Index Series Wealth-weighted indices developed in partnership with Global Wealth Allocation (GWA); constituents
are chosen based on their fundamentals: book value, cash flow and net income.
MSCI Factor Indices Alternatively-weighted, optimized indices, which utilize Barra’s risk model. Long-only factor indices
include momentum and value tilts; the base universe is the MSCI Europe Index.
Long-short factor indices include momentum, volatility, leverage, value, and earnings yield;
the base universes are MSCI Europe and MSCI USA.
MSCI Value and Growth Indices Market capitalization-weighted indices that generally categorize companies as growth or value based
on the following: Growth—high sales growth, high earnings change to price and momentum in the
current market; Value—high book value-to-price ratios, high earnings-to-price ratios and high
sales-to-price ratios.
Russell Value Indices Market capitalization-weighted indices that includes companies with lower price-to-book ratios and
lower forecasted growth values.
SP Growth and Value Indices Market capitalization-weighted indices that generally categorize companies as growth or value based
on the following: Growth—high sales growth, high earnings change to price and momentum in the
current market; Value—high book value-to-price ratios, high earnings-to-price ratios and high sales-
to-price ratios.
High Dividend Yield Indexes Considered to be a
Form of Value Index:
FTSE High Dividend Yield Index Dividend yield weighted index that was created in partnership with Vanguard; index consists of
stocks that have reported higher-than-average historical dividend yield. Index universe is based on
the US component of the FTSE Global Equity Index Series (GEIS).
MSCI High Dividend Yield Indices Family of dividend yield-weighted indices that consists of stocks that have historically yielded
higher than average dividend yields; can be based on all MSCI Developed Market Country and
Regional Indices.
SP Dividend Opportunities Indices Dividend yield-weighted indices that are comprised of historically high dividend paying companies;
index family includes: ASX Australia, CITIC China A-Share, Emerging Markets, Europe, Global,
International and Pan Asia indices.
SP High Yield Dividend Aristocrats Index Dividend yield-weighted index that is comprised of 60 companies with the highest dividend yields in
the SP Composite 1500 that have a consistent record of increasing dividend payments each year
over a period of 25 years.
Most of these indexes have tended to overperform in the long run.
The relative consistency of the several possible tilts is illustrated in Figure 1.

3. SSgA CAPITAL INSIGHTS | VALUE TILT PORTFOLIO
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The analysis of the characteristics of the Value Tilt Portfolio
shows that this implementation can achieve the desired low
valuation tilt through a number of improvements over the
benchmark—higher dividend yield, lower Price/Earning, lower
Price/Cash Flow, lower Price/Book and lower Price/Sales.
The factor exposure that the Value Tilt Portfolio expresses can
be viewed through the Axioma factorial model. Axioma reports a
high exposure on the Axioma value factor and low exposure on
the Axioma growth factor.
This Hypothetical Value Tilt Portfolio has predominantly
overperformed for the past 22 years. Advantageously, from a
risk point of view the volatility, or the maximum drawdown of the
portfolio, remains in line with the MSCI World indexes.
Academic Explanation of Drivers of the Value Tilt Overperformance
From the above figures, it seems that value strategies have clearly
tended to overperform over the past 20 years, though there are
periods when value strategies can significantly underperform.
What are the possible drivers for this, and is it reasonable
to believe that those drivers are going to deliver similar
overperformance in the future?
The explanations can be grouped into 3 categories.
The first explanation is that the overperformance is coincidental.
The market is fully efficient and the market portfolio is
the best portfolio on the long term. Overperformance is a
coincidence relative to the period, and there is no reason for
this overperformance to continue in the future. If the market is
split between value and growth, in a certain period of time, one
style will overperform the other style; there may be no structural
reason for this. Malkiel (2005) supports this view with the
strong argument that there is no empirical evidence of any fund
having beat the market on a consistent basis. However, there
remains the long-term (more than 50 years) evidence of value
overperformance that would have to be explained away.
The second explanation is rational. The value tilt overperforms on
a structural basis but this overperfomance is the price paid for an
Figure 2: Characteristics of Hypothetical Value Tilt Portfolio
Characteristics Value Tilt MSCI World
Market Capitalization Average 66,213 69,905
Dividend Yield 3.41 2.87
Price/Earnings 11.79 12.72
P/E using FY1 Est. 10.81 11.78
Price/Cash Flow 8.88 10.48
Price/Book 5.41 6.59
Price/Sales 1.65 6.34
Source: SSgA, Factset. As of Dec 2011.
Past performance is not a guarantee of future results.
Characteristics are as of the date indicated, are subject to change, and should not be relied
upon as current thereafter.
Figure 3: Factor Exposure of Hypothetical Value Tilt Portfolio
Factor Exposure
Value Tilt
(%)
MSCI World
(%)
Difference
(%)
Value 15 -1 17
Leverage 5 0 6
Exchange Rate Sensitivity 0 -4 4
Short-Term Momentum 15 13 3
Volatility -7 -6 -1
Size 23 24 -1
Liquidity 18 26 -8
Medium-Term Momentum -4 6 -10
Growth -16 0 -16
Source: SSgA, Axioma. As of Dec 2011.
Above factor exposures are as of the date indicated, are subject to change,
and should not be relied upon as current thereafter.
Figure 1: Characteristics of Selected Value Indexes
Statistics Over 11/95–11/10
MSCI
World Index
MSCI World
Value Weighted
MSCI World BV
Value Weighted
MSCI World
Earnings Weighted
MSCI World Cash
Earnings Weighted
MSCI World
Sales Weighted
MSCI World
Dividend Weighted
Case Number 1 2 3 4 5 6 7
Return (%) 5.69 7.04 5.69 7.70 7.22 7.75 7.73
Risk (%) 16.10 16.80 17.80 16.50 16.10 16.70 16.10
Return / Risk 0.35 0.42 0.33 0.47 0.45 0.46 0.48
Tracking error (%) 0.00 3.54 3.76 3.52 2.82 3.73 4.60
t-stat 5.19 0.66 7.38 6.78 7.25 5.56
Source: MSCI
Past performance is not a guarantee of future results.
Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income.
Characteristics are as of the date indicated, are subject to change, and should not be relied upon as current thereafter.

4. SSgA CAPITAL INSIGHTS | VALUE TILT PORTFOLIO
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additional risk. This risk is not the basic risk of additional volatility
since it appears the volatility of the value tilt is comparable to the
volatility of the benchmark. The market is simply a more complex
framework than the classical CAPM. Fama and French (1996)
have developed this view through the 3 factors model where value
and size factors appear as additional risk premiums.
The third explanation has a behavioural basis. According to
behaviouralists, investors are not fully rational and tend to
overreact or are subject to irrational psychological bias. For
example, by extrapolating past performances, value stocks tend
to be too cheap and growth stocks tend to be too expensive.
When the overreaction is reversed, value stocks tend to
overperform growth stocks. Or substantial sales may be initiated
by some investors with other investors simply following this
trend; a behavior known as herding. A more recent approach
has been developed under the Noisy Market Hypothesis.
According to it, some trading activities are motivated by reasons
not related to price, and lead to distortions in price. Using a
fundamental approach may give an unbiased exposure. Arnott
(2005) has developed a new indexing approach following
this route.
Is the Hypothetical Value Tilt Portfolio Overperformance Linked
to Market Conditions?
Value Tilt strategy overperformance does not seem to
result in additional volatility. However, is it possible that the
overperformance is linked with a risk that appears only in
stressed markets? The Value Tilt Portfolio would then have no
overperformance in a quiet market.
We consider two quiet markets here: the low volatility market
and the high performance market. Low volatility months are
months where the past one-year volatility is below the average
one year volatility over the entire period. The high performance
months are the months where the past one-year performance
is above the average one-year performance over the entire
period. This is an ex post criteria—and as such is not an active
model for a portfolio—but simply a way to split the entire period
into stressed periods (higher volatility and lower performance
than average) and quiet periods (low volatility and higher
performance than average).
The High Performance Value Tilt portfolio is invested in the
Value Tilt portfolio in high performance markets and in the
MSCI World index in low performance markets.
Similarly, the Low Volatility Value Tilt portfolio is invested in the
Value Tilt portfolio in low volatility markets and in the MSCI
World index in high volatility markets.
It appears that the high performance value tilt portfolio or
the low volatility value tilt portfolios have returns and risks
comparable to the MSCI World. The greatest part of the value
tilt portfolio’s overperformance is achieved during stressed
markets, when volatility is high and performance is low.
The value premium, then, could be interpreted as a premium for
investors who are able to buy or to stay invested during periods
of stressed markets when the pressure to not invest or to sell is
higher. This pressure could be psychological, in which case the
explanation of the value premium is more behavioural, or it could
be material (legal risk ratio or risk of bankruptcy for instance), in
which case the explanation of the value premium is more rational.
Figure 5: Characteristics of Hypothetical Value Tilt Portfolio
(Gross of Fees)
Back-tested
Returns and Risk
Characteristics
Value Tilt
(%)
High
Performance
(%)
Low Volatility
Value
Tilt (%)
MSCI
World (%)
Annual Return 8.00 6.77 6.51 6.13
Volatility 15.97 15.66 15.60 15.68
Frequency of Value
Tilt Invested
100 63 51 0
Source: SSgA. From 1989 to 2011, in USD.
Figure 6: Relative Value Tilt Performance in Diverse Environments
(From Base 1)
Source: MSCI, Factset.
2
0
4
6
8
10
Jan
1989
2009 Jan
2011
200520011993 1997
— Value Tilt
— High Performance Value Tilt
— Low Volatility Value Tilt
— Msci World
Figure 4: Drawdown and Return Characteristics of Hypothetical
Value Tilt Portfolio (Gross of Fees)
Back-tested Returns
Characteristics
Value Tilt
(%)
MSCI World
(%)
Difference
(%)
Annual Return 8.00 6.13 1.87
Volatility 15.97 15.68 0.29
Max Drawdown -58.80 -53.70 -5.17
Tracking error 3.79
Source: SSgA. From 1989 to 2011, in USD.

5. 5
SSgA CAPITAL INSIGHTS | VALUE TILT PORTFOLIO
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The views expressed in this material are the views of Frederic Jamet through the period ended 30 November 2012 and are subject to change based on market and other conditions. The informa-
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Conclusion
Value portfolios have proliferated and now include many
well-known indexes such as the FTSE RAFI index and the
MSCI High Dividend Yield index. A typical value portfolio
exhibits the classic characteristics of value—notably a fairly
consistent overperformance against the MSCI World over the
past 20 years with a comparable level
of volatility.
It is somewhat difficult to determine what best explains their
performance; between the rational approach, where value can
be viewed as an additional risk premium, and the behavioural
approach, where value is a rational way to take profit from
noisy trading.
It appears, however, that the major part of value overperformance
occurs in stressed markets, when volatility is high or performance
is low. One interpretation could be that value is the premium
associated with the investor’s capacity to continue to hold the
value portfolio during difficult times or to support the possibility
of bankruptcy risk.