The Value Indices Our Financial System Relies Upon May Be Invalid

June 15, 2021 EDT

We believe 70+ value ETFs traded on NYSE are tracking outdated metrics.

Value indices have been around for decades. Prominent names include S&P 500 Value Index, Russell 3000 Value Index, MSCI World Value Index, and countless more. Financial institutions not only use them as benchmarks for performance comparisons, but also as reflections of their financial products. More than $8 trillion USD are invested in passively managed ETFs that track indices by mirroring their holdings. A significant chunk of passively managed ETFs is composed of value ETFs, ETFs that track value indices as those mentioned above.

What a shame it would be if the indices our financial system relies so heavily upon may actually be outdated. Unfortunately, we feel investors today live that shame.

According to S&P, there are 3 main criteria for a stock to be considered part of a value index: its book value to price ratio (P/B), earnings to price ratio (P/E), and sales to price ratio (P/S). Of the 3, the first is most concerning.

The book value to price ratio compares a company’s market capitalization to its asset values. A low price to book ratio would suggest that a stock is undervalued and hence could be a lucrative investment. A major criticism for this ratio, however, is that it completely disregards the value of intangible assets. Sans the intangible assets, the value of total assets of a company are likely immensely understated.

As of September 2020, the value of intangible assets of the top 10 companies in the world was $10.8 trillion. Given the technological advancements within the business paradigm, companies’ proportion of intangible assets are likely to increase exponentially. In 1975, intangible assets represented only 14% of S&P 500 companies’ assets. In 2018, the percentage was at least 84%.

- Brand Finance. (2020, October). Global Intangible Finance Tracker (GIFT) – an annual review of the world’s intangible value.

With the value of intangible assets potentially understated, the P/B ratios of companies heavily invested in intangibles look unfairly unattractive.

The indices’ limitations do not stop there. Index constituents are first ranked based on their growth and value scores, and then sorted in ascending order of the growth / value rank ratio. The top 33% are placed in the growth index basket; the bottom 33% are placed in the value index basket; and the middle 34% are spread between the two indices depending on their scores. This means that stocks with little value characteristics are often designated to value indices, just because they have low growth ranks.

Furthermore, value indices are rebalanced at long intervals. The S&P 500 Value Index is rebalanced quarterly; the MSCI World Value Index semi-annually; and the Russell 3000 Value Index and the S&P 500 Pure Value Index annually. The inevitably creates time lags between performance realizations and subsequent adjustments. Even if the index issuer realizes securities’ value characteristics have worn out, she needs to wait until the next rebalancing period to adjust the weightings of index constituents.

What does this mean for investors?

Investors who invest in passively managed value ETFs (ETFs that mirror a value index) may be, in essence, investing in a pool of securities that only remotely resemble value stocks. We believe the epitome of value investing would be picking stocks based on not only companies’ sales and earnings, but also on the value of their intangible assets. By indices’ failure to do so, we believe investors may also be failing. Moreover, even if the ETF is carrying stocks that carry little or no “value” characteristics, the issuer must wait until the parent index has been rebalanced appropriately.

Some Investors who have picked this up have been relying upon AI to calculate companies’ intangible assets and invest accordingly. Through machine learning, artificial intelligence may be able to pick up important data in a plethora of fields and attempt to produce accurate projections for stocks’ growth potential. NVQ, of Qraft Technologies, is an ETF that invests in value stocks, depending on their intangibles. (It is rebalanced on a monthly basis.) The AI model, by gauging intangible assets in an aim to correct the traditional value metrics, is up 22.67% since its inception on 12/02/20 on the New York Stock Exchange until 3/31/21.

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