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Value Stocks Gaining Traction: Are Your Clients Prepared?

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What You Need to Know

  • Value stocks have shown some signs of coming back into favor in 2021.
  • From a valuation standpoint, value benchmarks are more attractive relative to their historical averages than growth indices.
  • A long/short equity fund offers protection from the broader market, while at the same time maximizing the gains from a divergence in growth and value.

After a long run for growth stocks, value has shown some signs of coming back into favor in 2021, and many investors wonder whether it may represent a changing of the guard among investment styles.

Those in the value camp note several trends that could favor the stocks going forward, including an ongoing economic recovery and continued signs of inflation. The latter could lead to a rise in interest rates, which penalizes the valuations of growth stocks more than value.

From a valuation standpoint, value benchmarks are also more attractive relative to their historical averages than growth indices. Perhaps more simply, many believe that after growth stocks outshined value for more than a decade, maybe it’s time that value had its day.

Whatever the reason, if advisors and their clients believe value is set for a longer run, a key question is: How best to invest in the trend? It may not be as simple as making a modest asset allocation shift toward value strategies. The reason: Most value strategies still have a high correlation to the broader market. For example, the Russell 1000 Value Index has a correlation of 0.95 and a beta of 1.00 to Russell 1000 Index.

That means an investor who pivots toward value strategies will not see much difference in their portfolio returns than had they kept their original allocation or simply invested in a core equity strategy. And if markets fall — a concern for some investors given where valuations sit today — the high correlation means the value-tilted portfolio will still bear much of the market’s returns, even if it outperforms growth.

A different way to invest behind the trend is through long/short equity funds, or other alternative strategies that use factors as the basis for determining which stocks to short.

Isolating the Divergence

For advisors who believe value is poised to outperform growth and want to invest behind the change, long/short equity funds may provide a better option to isolate that view.

Many long/short equity funds decide what stocks to short or invest long based on what factors they believe are likely to out- or underperform. A straightforward example of how using a long/short equity portfolio could put more emphasis on the value exposure would be to imagine a portfolio that is long the value factor and short growth stocks. This type of strategy would essentially capture both sides of the growth and value divergence, providing the potential to increase expected return without pure beta exposure (or at least controlled beta exposure). The investor’s active risk bet is more concentrated on the dynamic between value and growth.

Long/short equity funds offer another benefit relative to an active or passive value strategy: Lower market correlation. The long/short equity fund’s ability to take both long and short positions has historically helped such strategies perform well when markets are down because the gains from the short positions can offset the losses in long ­positions.

In summary, the long/short equity fund could offer the investor protection from the broader market, while at the same time maximizing the gains from a divergence in growth and value.

There are, of course, still key questions advisors must consider about a long/short equity fund. Advisors will have to perform necessary due diligence on a manager’s investment process. That includes questions about how they select what factors to short or invest long, and how a manager dynamically adjusts factor positioning. For example, if the value factor enjoys relative outperformance over a long window, how and when would the fund change positioning?

But advisors interested in investing behind a growth to value rotation — or other rotations favoring new factors — should give factor-based long/short equity strategies a closer look.

Josh Vail, CAIA, is managing director of Hamilton Lane.