The long-term tracking error (1962–2015) of FTSE RAFI US 1000 relative to the S&P 500 Index was 4.2% annualised,4 not exactly an “extreme” concentrated deep-value strategy. And yet, pronounced cyclicality is a reality. In the warmest of summers, FTSE RAFI US 1000 may outperform by 20% or greater, as it did in the aftermath of the tech bubble or after the darkest hours of the global financial crisis. Nonetheless, even a 4.2% tracking error allows for deep pain, as exemplified by the negative return posted in 2015.

We must remember, however, that seasons come and seasons go. Eventually long winter nights will give way to seemingly endless summer days in which we can enjoy the ripened fruits of seeds planted much earlier. Our notes then will be sun-filled postcards reporting stupendous excess returns. But summer weeks, like their preceding wintry months, succumb to the passage of time—and anchoring on their lost splendour only makes the next winter that much more difficult to tolerate.

Global Winter—Not Just the Northern Hemisphere
The same performance pattern for value relative to cap-weighted indices realised over the last decade in the United States also holds for similar strategies beyond the United States. In the long term, RAFI-based international strategies produced meaningful value-add, outpacing cap-weighted benchmarks by 1.94% (developed equities), 2.35% (developed equities ex U.S.), and 3.43% (emerging markets), as reported in Table 2. Shorter-term horizons, however, reveal a different story.



For the three years ending December 2015, the FTSE RAFI Developed 1000 ex US Index underperformed the cap-weighted MSCI World ex US Index by a handful of basis points (−0.04%); by comparison, the MSCI World ex US Value Index underperformed by −2.42%. Over the same period, in emerging markets, where value has been most severely punished, the RAFI strategy more pronouncedly underperformed, down −4.82% versus the MSCI Emerging Markets Value Index underperformance of −3.08%, both relative to the cap-weighted benchmark. Indeed, the winter in value-land is being felt around the globe.

Last-Minute Winter Getaways
The long and unforgiving winter in value-land has left many investors understandably craving a little sunshine. We’ve been there—caught in the grip of a steely grey winter—desperately jumping on the internet to book a last-minute flight to an island paradise for a couple of days, only to return tired and poorer. Much like last-minute tickets to the Caribbean or Mediterranean have a nasty habit of being extremely expensive in the darkest days of February, the getaways available to investors seeking relief from their recent experience in value strategies may prove expensive and disappointing.

Consider the market darlings known by their acronym FANG5 (Facebook, Amazon, Netflix and Google, now Alphabet). Collectively, as illustrated in Figure 4, the stock prices of these four companies increased 200% from June 2012 to year-end 2015. In addition, the collective P/E of the four nearly doubled over the same period, indicating their stupendous returns are largely a result of their becoming more expensive, much like the cost of that last minute trip! The rise in the FANG stocks’ collective P/E is of particular note when compared to the P/E of the S&P 500 at year-end—approximately 42 vs. 20. For a few days in early February 2016, Google overtook Apple in terms of market capitalization, a dubious honour and not an encouraging sign for investors jumping into Google after such a run-up.  This move, of course, isn’t all that has occurred in the early weeks of 2016. The market has seriously corrected, taking with it the prices of the FANG stocks, very possibly an early crack in growth stocks’ running the table.



Another perspective on cyclicality is a recent study by Arnott et al. (2016) that examines six common U.S. equity strategies—value, positive momentum, small cap, illiquid, low beta, and high gross profitability—since 1967. A comparison of the relative valuation and subsequent relative performance for each indicates a strong link between the two: the market’s performance-chasing behaviour has created much of the factor’s return. This rise in relative valuation not only boosts past relative performance, it also opens the door for subsequent lower returns when valuations revert to historical norms. In fact, seeking a “return”-getaway in any of the five strategies (other than value) analysed in the study appears to invite an expensive one-way ticket to underperformance when valuations inevitably adjust.

Restorative Summer Holidays
Similar to the angst experienced by blizzard-trapped and drizzle-logged denizens of frozen and bitter climes, the pain felt by value investors is tangible. In the midst of the dreariest days, it’s all too easy to overlook the fact that these exact conditions presage a reversal in seasons and will eventually usher in a possibly extended span of strong returns for disciplined value investors. Mean reversion has shown itself to be a reliable and powerful force, and the most persistent investment opportunity for long-term investors.

Could we attempt to assess the “turn” in the weather by relying on our observations of past and current signals? Of course, but past is not prologue. Rather, we are taking shelter from the adverse elements in a disciplined value-oriented strategy. A boon of fundamental index–based strategies is their persistent ratchet-like moves to a deeper value posture whenever value rotates out of favour or further out of favour. Then, when the inevitable snap-back in mean reversion occurs, these strategies should recover significantly more than the losses they endured during the value winter. As time and experience has repeatedly proven, disciplined value investors, such as ourselves, will be rewarded—one day (we hope soon!) to be basking in long-awaited summer breezes.

We would like to believe that the first few weeks of 2016 are the beginning of the winter thaw, as expensive, growth stocks come under pressure. Are we experiencing an inflection point? Are summer days just ahead? Only time will tell. But we are confident enough in the coming warmer weather that we are perusing the book stand to choose our beach reading list and searching the attic to locate our luggage under the eaves.

Endnotes
1. This positive outlook may very well be why we both work for an American enterprise, and one of us made a home in the United States more than half a lifetime ago.
2. Kenneth R. French - Data Library
3. This exceptionally long episode (29 months) of poor performance in value stocks extended from September 1989 to January of 1992; the recent rut for value, according to the same data series, is in its 15th month.
4. Other FTSE RAFI Index strategies have exhibited annualised tracking error in the 4–6% range over the 1962−2015 period.
5. Being included in an acronym seems to be a highly contrarian indicator, at least based on the appearance of the now disgraced BRIC countries: Brazil, Russia, India, and China. These four nations went from beacons of hope to toxic waste in the eyes of global investors shortly after reaching acronym status. Keenly aware of the exaggerated mood swings of market participants, we trust the truth is somewhere in the middle—neither beacons of hope nor toxic waste.

References
Arnott, Robert D., Noah Beck, Vitali Kalesnik, and John West. 2016. “How Can ‘Smart Beta’ Go Horribly Wrong?” Research Affiliates Fundamentals (February).

Brightman, Chris, Jonathan Treussard, and Jim Masturzo. 2014. “Our Investment Beliefs.” Research Affiliates Fundamentals (October).

Hsu, Jason, Brett W. Myers, and Ryan Whitby. 2016. “Timing Poorly: A Guide to Generating Poor Returns While Investing in Successful Strategies.” Journal of Portfolio Management, vol. 42, no. 2 (Winter):90–98.

Charles Aram is director of Europe, Middle East and Africa region research at Research Affiliates Global Advisors (Europe).

Jonathan Treussard, Ph.D., is senior vice president of product management at Research Affiliates.

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