Commentary by Viktor Nossek, Head of Investment and Product Analytics, Vanguard Europe

As global stock markets rebounded from the initial shock of Covid-19 in the first quarter of 2020, so-called “growth” stocks—spearheaded by large technology groups—soared to ever-higher price-to-value multiples.

With value stocks now starting to outperform their growth counterparts—a trend that our research suggests could persist over the next decade—is allocating to value indices the only way to exploit this rotation? Or is there an alternative approach to effectively capture the value factor that can help avoid some of the unintended consequences of traditional value strategies?

Growth stocks reach lofty valuations

Even before the advent of the coronavirus crisis, technology-led growth stocks had been riding high relative to their value counterparts in the low-inflation environment that had prevailed since the 2008 global financial crisis. Then came Covid-19 and, fuelled in part by the trend towards increased digitalisation during the pandemic, technology stocks in particular have risen to price-to-book value multiples not seen since around the time of the peak of the dot-com bubble.

And even after taking into account the surge in performance of value stocks in the early months of 2021, the valuation premium of growth and technology stocks over value equities is nearing extremes not seen in a quarter of a century.

Technology-led markets trading at high multiples

High Dividend Exposures

Past performance is not a reliable indicator of future results.

Source: Bloomberg. Data from 1 January 1995 to 30 April 2021. Monthly observations. Valuation premium measured as the difference between MSCI World Information Technology and MSCI World Value price to book ratios. MSCI World Information Technology = MSCI World Information Technology Index; MSCI World Value = MSCI World Enhanced Value Index. Price to book multiples are calculated from index members' stock price and book value per share, in USD terms.

As with previous cycles, growth’s recent outperformance has likely sown the seeds for value’s resurgence on a relative basis. Now, amid a broadening economic recovery, it’s perhaps not surprising that many investors will be looking to position client portfolios to benefit from this cyclical rotation.

Tapping value, while avoiding value traps

The lure of value strategies is that some value stocks can offer the potential for attractive risk-adjusted returns at low (relative to their growth counterparts) price-to-value multiples.

However, they can also expose investors to “value traps”, where a company’s low valuations are underpinned by weak fundamentals. In other words, while some value stocks can offer investors latent returns, others may be priced by the market consensus at cheap valuations with good reason. Viewed through the lens of the Fama–French five-factor model, value traps are those stocks whose excess returns are sensitive to the value factor (that is, the excess returns of cheap over expensive stocks) but not to the profitability factor (the excess returns of high- over low-profitability stocks).

The chart below decomposes the returns of two indices—the MSCI World Enhanced Value Index and the FTSE All World High Dividend Yield Index—over a 13-year period. As one would expect, the value strategy loads to the value factor – but as the chart shows, it has a minimal loading to the profitability factor. This suggests that the index’s sensitivity tilts towards stocks with overall low profitability.

Fama & French factor loadings - high-dividend and value factor exposures

High Dividend Exposures

Past performance is not a reliable indicator of future results.

Source: Bloomberg, Fama & French Data Library, Vanguard. Data from 1 May 2008 to 31 March 2021, using monthly data and the longest joint data history available for the indices shown. FTSE All-World High Dividend Yield = FTSE All World High Dividend Yield Index; MSCI World Enhanced Value = MSCI World Enhanced Value Index. Both indices are net returns in USD. Factor loadings are regression beta coefficients to Fama & French factor return premiums. Please go to Fama & French Data Library for more information about Fama & French factor definitions and calculation methodology.

Certain high-dividend exposures—such as the FTSE All-World High Dividend Yield Index—on the other hand, not only capture the value factor (albeit with slightly less sensitivity than value strategies); they also score highly on the profitability factor, offering greater exposure to companies with robust profitability. By tilting away from “deep-value” propositions that are typically included in traditional value strategies, high-dividend strategies can help investors to mitigate the risk of value traps.

One way that high-dividend strategies can achieve this is through their index construction methodology. Market-cap-weighted high-dividend indices, such as the FTSE All-World High Dividend Yield Index, screen constituents by dividend yield then weight them according to market capitalisation. Weighting by market cap tends to favour more profitable companies, which score strongly on the profitability factor.

Many value indices, by contrast, weight constituents by value factor scores and don’t take market capitalisation into account, which can lead to low profitability factor loadings.

Understanding sector weightings

From a portfolio positioning perspective, using high-dividend exposures to access value stocks can help investors avoid certain unintended sector biases.

Given the dominance of big tech companies in the growth universe, many investors might expect the IT sector to represent a relatively small share of the value landscape. However, this is not reflected in all value indices, and it highlights why carrying out thorough due diligence of the methodology and underlying holdings of any index is crucial.

For example, as the chart shows, the MSCI World Enhanced Value Index has a weighting of 21% to the IT sector. The FTSE All World High Dividend Yield Index, in comparison, has an IT sector weighting of around half of this, at 11%.

The financial sector is another case in point. Amid the prospect of rising interest rates, steepening yield curves and heightened inflation risks, many investors might view financials as a lynchpin of a value portfolio which should thrive in such an environment.

But again, the underlying holdings of some value strategies might come as a surprise to some. As of the end of April this year, financials made up around 14% of the MSCI World Enhanced Value Index, versus more than 25% of the FTSE All World High Dividend Yield Index.

Sector weights – high-dividend and value factor exposures

High Dividend Exposures

Source: Bloomberg. Data as at 30 April 2021.

Investors seeking exposure to the value factor should also consider the diversification benefits of the indices they choose. For example, the FTSE All World High Dividend Yield Index comprises more than 1,640 securities, more than four times the breadth of the MSCI World Enhanced Value Index, which is made up of just 4001. Owing to the greater diversification, high-dividend indices may also offer lower volatility than traditional value strategies too2.

As investors consider the contrasting fortunes of growth versus value, they should also think about how they gain exposure to these factors. High-dividend yield strategies can be much more than just a source of income. They can also offer diversified exposures that capture the value factor with lower volatility than traditional value strategies while helping to mitigate value traps.

1 Source: Bloomberg. The FTSE All World High Dividend Yield Index comprised 1,642 constituents and the MSCI World Enhanced Value index comprised 400 constituents as at 31 May 2021.

2 Source: Bloomberg. Data from 7 October 2014 to 30 April 2021. The FTSE All World High Dividend Yield Index had an annualised volatility of 14.4% while the MSCI World Enhanced Value Index had an annualised volatility of 15.2% during the period.

Investment risk information

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested

Past performance is not a reliable indicator of future results.

Investments in smaller companies may be more volatile than investments in well-established blue chip companies.

ETF shares can be bought or sold only through a broker. Investing in ETFs entails stockbroker commission and a bid-offer spread which should be considered fully before investing.

The Funds may use derivatives in order to reduce risk or cost and/or generate extra income or growth. The use of derivatives could increase or reduce exposure to underlying assets and result in greater fluctuations of the Fund's net asset value. A derivative is a financial contract whose value is based on the value of a financial asset (such as a share, bond, or currency) or a market index.

Some funds invest in securities which are denominated in different currencies. Movements in currency exchange rates can affect the return of investments.

For further information on risks please see the “Risk Factors” section of the prospectus on our website at https://global.vanguard.com.

Important information

This is an advertising document. For professional investors only (as defined under the MiFID II Directive) investing for their own account (including management companies (fund of funds) and professional clients investing on behalf of their discretionary clients). In Switzerland for professional investors only. Not to be distributed to the public.

The information contained in this document is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so. The information in this document is general in nature and does not constitute legal, tax, or investment advice. Potential investors are urged to consult their professional advisers on the implications of making an investment in, holding or disposing of shares and /or units of, and the receipt of distribution from any investment.

Vanguard Funds plc has been authorised by the Central Bank of Ireland as a UCITS and has been registered for public distribution in certain EEA countries and the UK. Prospective investors are referred to the Funds' prospectus for further information. Prospective investors are also urged to consult their own professional advisers on the implications of making an investment in, and holding or disposing shares of the Funds and the receipt of distributions with respect to such shares under the law of the countries in which they are liable to taxation.

The Manager of Vanguard Funds plc is Vanguard Group (Ireland) Limited. Vanguard Asset Management, Limited is a distributor for Vanguard Funds plc.

For further information on the fund's investment policies, please refer to the Key Investor Information Document (“KIIDs”). The KIID for this fund is available in local languages, alongside the prospectus via Vanguard’s website https://global.vanguard.com/.

The Indicative Net Asset Value (“iNAV”) for Vanguard’s ETFs is published on Bloomberg or Reuters.  Refer to the Portfolio Holdings Policy at https://global.vanguard.com/portal/site/portal/ucits-documentation for holdings information.

London Stock Exchange Group companies include FTSE International Limited ("FTSE"), Frank Russell Company ("Russell"), MTS Next Limited ("MTS"), and FTSE TMX Global Debt Capital Markets Inc. ("FTSE TMX"). All rights reserved. "FTSE®", "Russell®", "MTS®", "FTSE TMX®" and "FTSE Russell" and otherservice marks and trademarks related to the FTSE or Russell indexes are trademarks of the London Stock Exchange Group companies and are used by FTSE, MTS, FTSE TMX and Russell under licence. All information is provided for information purposes only. No responsibility or liability can be accepted by the London Stock Exchange Group companies nor its licensors for any errors or for any loss from use of this publication. Neither the London Stock Exchange Group companies nor any of its licensors make any claim, prediction, warranty or representation whatsoever, expressly or impliedly, either as to the results to be obtained from the use of the FTSE or Russell indexes or the fitness or suitability of the indexes for any particular purpose to which they might be put.

The funds or securities referred to herein are not sponsored, endorsed, or promoted by MSCI, and MSCI bears no liability withrespect to any such funds or securities. The prospectus or the Statement of Additional Information contains a more detailed description of the limited relationship MSCI has with Vanguard and any related funds.

For Dutch investors only: The fund(s) referred to in this document are listed in the AFM register as defined in section 1:107 Dutch Financial Supervision Act (Wet op het financieel toezicht).For details of the Risk indicator for each fund listed in this document, please see the fact sheet(s) which are available from Vanguard via our website https://www.vanguard.nl/portal/instl/nl/en/product.html.

For Swiss professional investors: The Manager of Vanguard Funds plc is Vanguard Group (Ireland) Limited. Vanguard Investments Switzerland GmbH is a financial services provider, providing services in the form of purchase and sales according to Art. 3 (c)(1) FinSA. Vanguard Investments Switzerland GmbH will not perform any appropriateness or suitability assessment. Furthermore, Vanguard Investments Switzerland GmbH does not provide any services in the form of advice. Vanguard Funds Series plc has been authorised by the Central Bank of Ireland as a UCITS. Prospective investors are referred to the Funds' prospectus for further information. Prospective investors are also urged to consult their own professional advisors on the implications of making an investment in, and holding or disposing shares of the Funds and the receipt of distributions with respect to such shares under the law of the countries in which they are liable to taxation. Vanguard Funds plc has been approved for offer in  Switzerland by the Swiss Financial Market Supervisory Authority (FINMA). The information provided herein does not constitute an offer of Vanguard Funds plc in Switzerland pursuanttoFinSA and its implementing ordinance. This is solely an advertisement pursuant to FinSA and its implementing ordinance for Vanguard Funds plc. The Representative and the Paying Agent in Switzerland is BNP Paribas Securities Services, Paris, succursale de Zurich, Selnaustrasse 16, 8002 Zurich. Copies of the Articles of Incorporation, KIID, Prospectus, Declaration of Trust, By-Laws, Annual Report and Semiannual Report for these funds can be obtained free of charge from the Swiss Representative or from Vanguard Investments Switzerland GmbH via our website https://global.vanguard.com/.

Issued in EEA by Vanguard Group (Ireland) Limited which is regulated in Ireland by the Central Bank of Ireland.

Issued in Switzerland by Vanguard Investments Switzerland GmbH.

Issued by Vanguard Asset Management, Limited which is authorised and regulated in the UK by the Financial Conduct Authority.

© 2021 Vanguard Group (Ireland) Limited. All rights reserved.

© 2021 Vanguard Investments Switzerland GmbH. All rights reserved.

© 2021 Vanguard Asset Management, Limited. All rights reserved

801