Why we believe investors should always maintain a strategic allocation to value
We believe that investors should always maintain a strategic allocation to value within their portfolio given diversification benefits. Diversification means combining return streams that are unique and complementary with low or negative correlations of returns in order to reduce risk. You can see from Figure 1 that the trailing standard deviation for a 50/50 Value/Growth portfolio has had a lower total risk than either growth or value alone over the last 10 years.
Diversification is also a recognition that forecasting the future is difficult. If you cannot forecast the future, the natural alternative is to diversify. Because the value factor has its own unique risk premia, it is naturally diversifying to other factors like quality, size, risk, and growth and momentum. Growth is what has worked in recent history, and that style of investing is typically closely linked to momentum. Figure 2 details the rolling correlation between momentum and two simple measures of value, book-to-price and earnings yield. Often, momentum and value are negatively correlated, which makes sense given momentum reflects what has worked in recent history and value often reflects a holding that is cheap because the stock has not worked.
Today, the relationship between momentum and value is at an extreme, especially looking at the earnings yield correlation with momentum. Recently, earnings yield has had a negative correlation to momentum approaching -0.6. That correlation has eased somewhat to about negative 0.4, but that number is still extremely low by historical standards.
While we believe that momentum is an academically proven factor and works over the long-term, we also believe that the factor mean reverts (Mean reversion is a theory used in finance that suggests that asset price volatility and returns eventually will revert toward a long-term average level of the entire dataset). Moreover, when momentum turns, the fall can be swift and severe. For example, if we look at Figure 3, in 2009, as the economy started to recover following the global financial crisis, momentum significantly underperformed the broader market.
After an exceptionally strong run for momentum in recent years, it would be prudent to have a hedge and an offsetting exposure by increasing your value allocation in your portfolio today.
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The views expressed herein are those of Harbor Capital Advisors, Inc. investment professionals at the time the comments were made. They may not be reflective of their current opinions, are subject to change without prior notice, and should not be considered investment advice. The information provided in this presentation is for informational purposes only.
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