Should You Invest In "Growth", "Value", or Both? By IndexFunds.com Staff 1999

There is a big debate going on in the academic community about where the return premium on value stocks comes from. Note that the debate is not whether their is a premium, but rather its cause.

The folks at Dimensional Fund Advisors (DFA) are in the Modern Portfolio Theory/Efficient Markets camp and believe the premium is due to the higher risk of "distressed" companies. Others (behavioral economists or "inefficient" market proponents) believe this "distress" is overstated and value stocks represent a "mispricing" in the markets. They believe value stocks are actually less risky than growth stocks because most of the price risk has already been wrung out of these stocks.

Let's look at the data. Eugene Fama and Kenneth French created indexes based on the book-to-market ratios of large and small company stocks. In essence, "value" stocks are stocks with the highest 30% b-t-m ratios (or lowest prices relative to book value) and growth stocks have the lowest b-t-m ratios (highest prices relative to book value). Below are their findings.

7/63-6/98	U.S. Large Growth Stocks	U.S. Large Value Stocks		U.S. Small Growth Stocks	U.S. Small Value Stocks
Annual Return	11.4%	15.3%		12.3%	17.9%
Annual Volatility*	18.8%	15.3%		28.0%	23.1%
Return Premium		3.9%			5.6%

*the standard deviation of annual returns

Those coming down on the side of market inefficiency point to the lower volatility of value stocks as a proof that they are less risky than growth stocks. They also point to the lower downside risk of value stocks in many (but not all) of the down markets, as measured by the S&P 500 in calendar years.

Calendar Year	S&P 500	U.S. Large Growth Stocks	U.S. Large Value Stocks		U.S. Small Growth Stocks	U.S. Small Value Stocks
1967	-10.1%	-11.0%	-5.2%		-6.4%	-5.5%
1969	-8.5%	+.6%	-16.0%		-23.9%	-24.9%
1973	-14.7%	-20.3%	-2.8%		-39.1%	-26.0%
1974	-26.5%	-30.0%	-22.4%		-33.4%	-18.11%
1977	--7.2%	-9.1%	+.8%		+20.3%	+21.8%
1981	-4.9%	-7.9%	+11.2%		-4.1%	+10.5%
1990	-3.2%	+1.4%	-13.9%		-18.1%	-20.8%

An interesting detour on the way to these numbers is to run them from June-to-June instead of December-to-December. As you can see below, we "eliminate" the down markets of 1967, 1974, 1977, 1981, and 1990 and "replace" them with two new ones, 1983 and 1987. Obviously, if investors would just think in terms of June-end years, we would have fewer down markets!

June-June Year	S&P 500	U.S. Large Growth Stocks	U.S. Large Value Stocks		U.S. Small Growth Stocks	U.S. Small Value Stocks
1969	-22.8%	-23.4%	-22.7%		-44.2%	-32.5%
1973	-14.5%	-18.3%	-4.6%		-16.5%	-3.0%
1981	-11.4%	-16.0%	-2.9%		-21.5%	-7.9%
1983	-4.6%	-13.0%	+5.3%		-21.0%	-1.9%
1987	-6.9%	-10.4%	-1.0%		-9.0%	-.3%

One thing investors should notice is the closer correlation of the S&P 500 index to the growth stock index than to the value index. Except for the Vanguard Index Growth Portfolio, the closest choice investors have to the growth universe are the S&P 500-based funds.

The S&P 500 funds include the big name growth stocks such as Coca-Cola, Microsoft, Intel, Merck, etc. So, at least today, investors who exclude growth stocks from their portfolios in favor of the higher returns of value stock, excludes these names.

These numbers suggest that investors should definitely include value stocks in an indexed portfolio. But should they exclude growth stocks (and S&P 500 funds) altogether?

For investors with long investment time horizons, a value-only portfolio should generate higher returns with less volatility and downside risk. But these investors should understand that in any given year, or even several years in a row, it is probable that growth stocks will outperform. This is the reason many advisor recommend a combination of the asset classes.

IndexFunds.com Staff
©1999 IndexFunds.com