Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 308

The flaw in 'value' index funds

Value index funds have a fundamental flaw.

The problem is not in the principles of 'value investing'. Those are sound, and they trace back to at least 1934, when Benjamin Graham and David Dodd published Security Analysis, where they argue that investors should “be concerned with the intrinsic value of the security and … discrepancies between the intrinsic value and the market price”. Buying stocks at a discount to their intrinsic value makes sense.

For decades, researching companies like this was the only real way to engage in value investing. That changed in 1992, when Eugene Fama and Kenneth French identified the value 'factor' as a source of market-beating returns. If you simply closed your eyes and bought each company that trades at a low multiple of its book value, you could beat the market. Over the very long term, this factor approach to value investing has worked, too.

That didn’t escape the notice of index providers and asset managers, who started creating products to harness the value factor. Today, hundreds of billions of dollars are invested in value index funds and value exchange traded funds (ETFs).

The source of the problem

So if the principles of value investing are sound, and the factor approach works too, what’s the problem with value index funds and ETFs? The issue is in how the simplest and most widely-tracked value indices are constructed.

The world’s biggest value ETFs track major indices such as the S&P, MSCI, Russell, and CRSP. To build their value and growth indices, each of these providers start with two assumptions that have profound consequences:

  • Value and growth are opposites.
  • A stock’s weight in the value index plus its weight in the growth index should equal its weight in the ‘normal’ market index.

Though the shape of the diagram varies, we can argue that the methodology used has a framework that looks something like this:

How value ETFs categorise stocks

How value ETFs categorise stocks

Source: Orbis

For each stock, the index provider looks at one or more valuation measures, like price-to-book, price-to-earnings, and dividend yield, and then ranks all the stocks in the universe. The cheapest stocks get a high ‘value score’ and end up in the top half of the diagram above.

And because many people are interested in growth shares as well, the index providers do a similar exercise with fundamental metrics such as earnings growth. Stocks with the best fundamentals get a high ‘growth score’ and end up on the right side of the diagram above.

So far, so good. In a simplistic way, we know which stocks are cheap and which companies are good.

Why can’t value and growth be friends?

The trouble comes with the next step.

To decide whether a stock should go in the value index, the growth index, or both, the index providers look for purity. Remember, this pre-determined framework sets up ‘cheap stock’ and ‘good company’ as opposites.

In a way, pitting value and growth against each other is similar to assuming that the market is efficient. Cheap stocks must be cheap for a good reason, and expensive ones must be expensive for a good reason. You always get what you pay for, and you always have to pay for what you get. However assuming this sort of efficiency goes against the whole purpose of factor investing!

In their search for purity, the index providers don’t just put all the cheap stocks in the value index as you might expect. Instead, the clearest candidates for the value index are stocks that have high value scores and low growth scores. Rather than calling this ‘value’, you might call it ‘value and anti-quality’. Or ‘cheap junk’. These stocks, we believe in quadrant A, are the core of every big value ETF.

The same thing happens on the growth side. Growth ETFs do not just buy the companies with the best growth. They focus on stocks that have high growth scores and low value scores. Growth and anti-value. Expensive quality only - the stocks in quadrant C.

The rest of the shares aren’t pure. They’re either value and growth, in quadrant B, or neither value nor growth, in quadrant D. These shares get their weights split between the value and growth indices. No stock is left behind!

Strange results

Think for a moment about your perfect stock. For most of us, it would be a profitable, fast-growing company trading at a dirt cheap valuation. In other words, the stock would sit squarely in quadrant B - cheap quality. Buying these stocks is such a good idea that Joel Greenblatt’s ‘magic formula’ book has sold hundreds of thousands of copies. But magic is not what you get in a value or growth ETF.

Instead, you get a bizarre compromise. For the value index, we’ve identified the cheap stocks, and then downweighted the ones with good fundamentals. And for the growth index, we’ve identified the good companies, then downweighted the ones that are cheap. Neither the value nor the growth ETF gets all of the best stocks, and both of them share the expensive junk—stocks that really ought to be left behind. That may be elegant for the construction of an index family, but it is far from ideal if your goal is attractive returns.

The scope of the problem

We can quantify the hit to investors’ returns, using factor data from Kenneth French. Here, we’ve substituted profitability in for growth as a measures of “good companies”, but the returns here are highly correlated with those of commercial value and growth ETFs. And while this data is for the US given the longer available history (back to 1963), the same patterns hold for global shares over a shorter horizon.

From the numbers, it’s clear where you want to be - buying quality at a reasonable price (B) is the clear winner, beating expensive junk (D) by 4.3% p.a. That amounts to a staggering 10x difference in ending wealth over the full 56-year period. But notice that other things work too. If you ignore fundamentals and buy the low-quality stocks (A and D) or ignore valuations and buy the good companies (B and C), you can also get a reasonably nice return. Value works, and quality works.

But as we’ve presented, you don’t get value in the biggest value ETFs. You get value and anti-quality, or cheap junk. And if you buy cheap junk (A) and (½ of B and ½ of D) or expensive quality (C) and (½ of B and ½ of D), you get the same return as buying all the stocks in the universe. It’s not worth the bother.

Solving the problem

The fundamental problem with value ETFs is that we believe, they target stocks with poor fundamentals. Fortunately, this is a fairly easy problem to solve. Don’t be anti-quality, and don’t be anti-value. Be pro both. Try to buy good companies at low prices, be patient, and enjoy the rewards. In other words, get back to value investing in its original sense - purchasing companies at a discount to their intrinsic value.

 

Graeme Shaw and Rob Perrone are Investment Specialists at Orbis Investments, a sponsor of Firstlinks. This report constitutes general advice only and not personal financial or investment advice. It does not take into account the specific investment objectives, financial situation or individual needs of any particular person.

For more articles and papers from Orbis, please click here.

 

RELATED ARTICLES

How do different investing styles work?

Index funds invest in the bad and the good

Are markets broken?

banner

Most viewed in recent weeks

16 ASX stocks to buy and hold forever, updated

This time last year, I highlighted 16 ASX stocks that investors could own indefinitely. One year on, I look at whether there should be any changes to the list of stocks as well as which companies are worth buying now. 

2025-26 super thresholds – key changes and implications

The ABS recently released figures which are used to determine key superannuation rates and thresholds that will apply from 1 July 2025. This outlines the rates and thresholds that are changing and those that aren’t.  

Is Gen X ready for retirement?

With the arrival of the new year, the first members of ‘Generation X’ turned 60, marking the start of the MTV generation’s collective journey towards retirement. Are Gen Xers and our retirement system ready for the transition?

Why the $5.4 trillion wealth transfer is a generational tragedy

The intergenerational wealth transfer, largely driven by a housing boom, exacerbates economic inequality, stifles productivity, and impedes social mobility. Solutions lie in addressing the housing problem, not taxing wealth.

What Warren Buffett isn’t saying speaks volumes

Warren Buffett's annual shareholder letter has been fixture for avid investors for decades. In his latest letter, Buffett is reticent on many key topics, but his actions rather than words are sending clear signals to investors.

The 2025 Australian Federal election – implications for investors

With an election due by 17 May, we are effectively in campaign mode with the Government announcing numerous spending promises since January and the Coalition often matching them. Here's what the election means for investors.

Latest Updates

World's largest asset manager wants to revolutionise your portfolio

Larry Fink is one of the smartest people in the finance industry. In his latest shareholder letter, the Blackrock CEO outlines his quest to become the biggest player in private assets and upend investor portfolios.

Economy

Australia's economic report card heading into the polls

Our economy grew by a nominal rate of 7% per annum from 2017 to 2024, but it benefited from the largesse of fiscal and monetary policies, both of which are now fading. We need a new, credible economic growth agenda.

Preference votes matter

If the recent polls are anything to go by, we are headed for a hung parliament at the upcoming federal election. So more than ever, Australians need to give serious consideration to their preference votes.

SMSF strategies

Meg on SMSFs: Tips for the last member standing

It’s common for people as they age to seek more help in running their SMSF if their capacity declines. An alternate director may be a great solution for someone just planning for short-term help in the meantime.

Wilson Asset Management on markets and its new income fund

In this interview, Matthew Haupt from Wilson Asset Management discusses his outloook for the ASX, sectors such as REITs that he likes, and his firm's launch of a new income-oriented listed investment company.  

Planning

‘Life expectancy’ – and why I don’t like the expression

Life expectancy isn't just a number - it's a concept that changes with survival rates over time. This article breaks down how age, survival, and societal factors shape our understanding of life expectancy, especially post-Covid. 

The shine is back on gold, and gold miners

Gold mining stocks outperformed in 2024 and are expected to do well in 2025. At this point in the rally, it's worth considering what has driven gold prices higher and why miners could still have some catching up to do.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.