Part of State Street’s Vision thought leadership series

SSgA CAPITAL INSIGHTS THE EXCHANGE

What Drives Value Tilt Portfolios’ Overperformance?

Markowitz and Sharpe’s Modern Portfolio Theory has notably

focused on the concept of efficient portfolios and the Capital Asset

Pricing Model, where any additional return from a market-cap

portfolio has an additional cost in terms of risk. Subsequent work

by Fama and French has since identified two further risk premia

that appear to provide additional structural return: the small cap

and the value premia.

Whereas the small-cap premium may be explained in terms

of beneficial low liquidity and high cost, the value premium

although apparently consistent, can be more difficult to

explain. The value premium can be captured through several

methodologies. Several academic explanations of value’s

overperformance, with both rational and irrational bases,

have been proposed. It does seem clear, however, that value

overperformance can be linked to

market risk.

Construction

At a basic level, value indexes tilt the market-cap portfolio

towards low valuation stocks. Low valuation stocks are defined

as having a low price relative to any fundamental accounting

figure. Historically, the typical figure used has been the

price-to-book ratio. This ratio was used to create one of the

first value and growth indexes.

Dividends may also be considered, and the index then becomes

a low price-to-dividend index, also known as a high dividend

yield index. Other common fundamental metrics are earnings,

sales or cash flow.

The weighting scheme can be a tilt applied to the market-cap

portfolio, or to an equal-weighted portfolio or it may be

constructed from an optimization. The universe can be the full

initial universe, half of it, in case of a value and growth index,

or a lower proportion, in the case of a high dividend yield index.

Although the basic idea is simple, there is now a proliferation of

value indexes in the market.

The Value Tilt Portfolio

Consider a Value Tilt portfolio that can be constructed by

splitting the investable universe into 20 market capitalization

buckets of 5% each, ranked by valuation. Each bucket is

then tilted according to the bucket valuation versus the total

average valuation. The valuation is computed using the 5-year

exponential average of 5 factors: sales, earnings, dividends,

book value and cash flow. This Value Tilt Portfolio is readjusted

once a year.

by Frederic Jamet Head of Investments, SSgA France

SSgA CAPITAL INSIGHTS | VALUE TILT PORTFOLIO

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Overview of Available Value Indexes

Three of the Most Well-known Value indexes

FTSE RAFI Index Series Fundamentally-weighted index series developed in partnership with Research Affiliates LLC; securities are ranked by the following four factors: dividends, cash flow, sales and book value.

MSCI Value Weighted Indices Alternatively-weighted indices where constituents are weighted by valuation factors including: sales, earnings, cash earnings and book value; available for a number of MSCI Global Indices.

Russell Fundamental Indices Fundamentally-weighted index series developed in partnership with Research Affiliates LLC; securities are ranked by the following three factors: adjusted sales, operating cash flow and dividends plus buybacks.

Different Versions Also Available:

FTSE ActiveBeta Index Series Alternatively-weighted indices that were developed in partnership with Westpeak Global Advisors and are constructed by ranking securities by value and momentum factors; index universes are derived from FTSE’s All-World Index Series.

FTSE GWA Index Series Wealth-weighted indices developed in partnership with Global Wealth Allocation (GWA); constituents are chosen based on their fundamentals: book value, cash flow and net income.

MSCI Factor Indices Alternatively-weighted, optimized indices, which utilize Barra’s risk model. Long-only factor indices include momentum and value tilts; the base universe is the MSCI Europe Index. Long-short factor indices include momentum, volatility, leverage, value, and earnings yield; the base universes are MSCI Europe and MSCI USA.

MSCI Value and Growth Indices Market capitalization-weighted indices that generally categorize companies as growth or value based on the following: Growth—high sales growth, high earnings change to price and momentum in the current market; Value—high book value-to-price ratios, high earnings-to-price ratios and high sales-to-price ratios.

Russell Value Indices Market capitalization-weighted indices that includes companies with lower price-to-book ratios and lower forecasted growth values.

S&P Growth and Value Indices Market capitalization-weighted indices that generally categorize companies as growth or value based on the following: Growth—high sales growth, high earnings change to price and momentum in the current market; Value—high book value-to-price ratios, high earnings-to-price ratios and high sales-to-price ratios.

High Dividend Yield Indexes Considered to be a Form of Value Index:

FTSE High Dividend Yield Index Dividend yield weighted index that was created in partnership with Vanguard; index consists of stocks that have reported higher-than-average historical dividend yield. Index universe is based on the US component of the FTSE Global Equity Index Series (GEIS).

MSCI High Dividend Yield Indices Family of dividend yield-weighted indices that consists of stocks that have historically yielded higher than average dividend yields; can be based on all MSCI Developed Market Country and Regional Indices.

S&P Dividend Opportunities Indices Dividend yield-weighted indices that are comprised of historically high dividend paying companies; index family includes: ASX Australia, CITIC China A-Share, Emerging Markets, Europe, Global, International and Pan Asia indices.

S&P High Yield Dividend Aristocrats Index Dividend yield-weighted index that is comprised of 60 companies with the highest dividend yields in the S&P Composite 1500 that have a consistent record of increasing dividend payments each year over a period of 25 years.

Most of these indexes have tended to overperform in the long run. The relative consistency of the several possible tilts is illustrated in Figure 1.

SSgA CAPITAL INSIGHTS | VALUE TILT PORTFOLIO

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The analysis of the characteristics of the Value Tilt Portfolio

shows that this implementation can achieve the desired low

valuation tilt through a number of improvements over the

benchmark—higher dividend yield, lower Price/Earning, lower

Price/Cash Flow, lower Price/Book and lower Price/Sales.

The factor exposure that the Value Tilt Portfolio expresses can

be viewed through the Axioma factorial model. Axioma reports a

high exposure on the Axioma value factor and low exposure on

the Axioma growth factor.

This Hypothetical Value Tilt Portfolio has predominantly

overperformed for the past 22 years. Advantageously, from a

risk point of view the volatility, or the maximum drawdown of the

portfolio, remains in line with the MSCI World indexes.

Academic Explanation of Drivers of the Value Tilt Overperformance

From the above figures, it seems that value strategies have clearly

tended to overperform over the past 20 years, though there are

periods when value strategies can significantly underperform.

What are the possible drivers for this, and is it reasonable

to believe that those drivers are going to deliver similar

overperformance in the future?

The explanations can be grouped into 3 categories.

The first explanation is that the overperformance is coincidental.

The market is fully efficient and the market portfolio is

the best portfolio on the long term. Overperformance is a

coincidence relative to the period, and there is no reason for

this overperformance to continue in the future. If the market is

split between value and growth, in a certain period of time, one

style will overperform the other style; there may be no structural

reason for this. Malkiel (2005) supports this view with the

strong argument that there is no empirical evidence of any fund

having beat the market on a consistent basis. However, there

remains the long-term (more than 50 years) evidence of value

overperformance that would have to be explained away.

The second explanation is rational. The value tilt overperforms on

a structural basis but this overperfomance is the price paid for an

Figure 2: Characteristics of Hypothetical Value Tilt Portfolio

Characteristics Value Tilt MSCI World

Market Capitalization Average 66,213 69,905

Dividend Yield 3.41 2.87

Price/Earnings 11.79 12.72

P/E using FY1 Est. 10.81 11.78

Price/Cash Flow 8.88 10.48

Price/Book 5.41 6.59

Price/Sales 1.65 6.34

Source: SSgA, Factset. As of Dec 2011.Past performance is not a guarantee of future results. Characteristics are as of the date indicated, are subject to change, and should not be relied upon as current thereafter.

Figure 3: Factor Exposure of Hypothetical Value Tilt Portfolio

Factor ExposureValue Tilt

(%)MSCI World

(%)Difference

(%)

Value 15 -1 17

Leverage 5 0 6

Exchange Rate Sensitivity 0 -4 4

Short-Term Momentum 15 13 3

Volatility -7 -6 -1

Size 23 24 -1

Liquidity 18 26 -8

Medium-Term Momentum -4 6 -10

Growth -16 0 -16

Source: SSgA, Axioma. As of Dec 2011.Above factor exposures are as of the date indicated, are subject to change, and should not be relied upon as current thereafter.

Figure 1: Characteristics of Selected Value IndexesStatistics Over 11/95–11/10

MSCI World Index

MSCI World Value Weighted

MSCI World BV Value Weighted

MSCI World Earnings Weighted

MSCI World Cash Earnings Weighted

MSCI World Sales Weighted

MSCI World Dividend Weighted

Case Number 1 2 3 4 5 6 7

Return (%) 5.69 7.04 5.69 7.70 7.22 7.75 7.73

Risk (%) 16.10 16.80 17.80 16.50 16.10 16.70 16.10

Return / Risk 0.35 0.42 0.33 0.47 0.45 0.46 0.48

Tracking error (%) 0.00 3.54 3.76 3.52 2.82 3.73 4.60

t-stat 5.19 0.66 7.38 6.78 7.25 5.56

Source: MSCIPast performance is not a guarantee of future results.Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income. Characteristics are as of the date indicated, are subject to change, and should not be relied upon as current thereafter.

SSgA CAPITAL INSIGHTS | VALUE TILT PORTFOLIO

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additional risk. This risk is not the basic risk of additional volatility

since it appears the volatility of the value tilt is comparable to the

volatility of the benchmark. The market is simply a more complex

framework than the classical CAPM. Fama and French (1996)

have developed this view through the 3 factors model where value

and size factors appear as additional risk premiums.

The third explanation has a behavioural basis. According to

behaviouralists, investors are not fully rational and tend to

overreact or are subject to irrational psychological bias. For

example, by extrapolating past performances, value stocks tend

to be too cheap and growth stocks tend to be too expensive.

When the overreaction is reversed, value stocks tend to

overperform growth stocks. Or substantial sales may be initiated

by some investors with other investors simply following this

trend; a behavior known as herding. A more recent approach

has been developed under the Noisy Market Hypothesis.

According to it, some trading activities are motivated by reasons

not related to price, and lead to distortions in price. Using a

fundamental approach may give an unbiased exposure. Arnott

(2005) has developed a new indexing approach following

this route.

Is the Hypothetical Value Tilt Portfolio Overperformance Linked to Market Conditions?

Value Tilt strategy overperformance does not seem to

result in additional volatility. However, is it possible that the

overperformance is linked with a risk that appears only in

stressed markets? The Value Tilt Portfolio would then have no

overperformance in a quiet market.

We consider two quiet markets here: the low volatility market

and the high performance market. Low volatility months are

months where the past one-year volatility is below the average

one year volatility over the entire period. The high performance

months are the months where the past one-year performance

is above the average one-year performance over the entire

period. This is an ex post criteria—and as such is not an active

model for a portfolio—but simply a way to split the entire period

into stressed periods (higher volatility and lower performance

than average) and quiet periods (low volatility and higher

performance than average).

The High Performance Value Tilt portfolio is invested in the

Value Tilt portfolio in high performance markets and in the

MSCI World index in low performance markets.

Similarly, the Low Volatility Value Tilt portfolio is invested in the

Value Tilt portfolio in low volatility markets and in the MSCI

World index in high volatility markets.

It appears that the high performance value tilt portfolio or

the low volatility value tilt portfolios have returns and risks

comparable to the MSCI World. The greatest part of the value

tilt portfolio’s overperformance is achieved during stressed

markets, when volatility is high and performance is low.

The value premium, then, could be interpreted as a premium for

investors who are able to buy or to stay invested during periods

of stressed markets when the pressure to not invest or to sell is

higher. This pressure could be psychological, in which case the

explanation of the value premium is more behavioural, or it could

be material (legal risk ratio or risk of bankruptcy for instance), in

which case the explanation of the value premium is more rational.

Figure 5: Characteristics of Hypothetical Value Tilt Portfolio (Gross of Fees)Back-tested Returns and Risk Characteristics

Value Tilt (%)

High Performance

(%)

Low Volatility Value

Tilt (%)MSCI

World (%)

Annual Return 8.00 6.77 6.51 6.13

Volatility 15.97 15.66 15.60 15.68

Frequency of Value Tilt Invested

100 63 51 0

Source: SSgA. From 1989 to 2011, in USD.

Figure 6: Relative Value Tilt Performance in Diverse Environments (From Base 1)

Source: MSCI, Factset.

2

0

4

6

8

10

Jan1989

2009 Jan2011

200520011993 1997

— Value Tilt— High Performance Value Tilt

— Low Volatility Value Tilt— Msci World

Figure 4: Drawdown and Return Characteristics of Hypothetical Value Tilt Portfolio (Gross of Fees)Back-tested Returns Characteristics

Value Tilt (%)

MSCI World (%)

Difference (%)

Annual Return 8.00 6.13 1.87

Volatility 15.97 15.68 0.29

Max Drawdown -58.80 -53.70 -5.17

Tracking error 3.79

Source: SSgA. From 1989 to 2011, in USD.

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SSgA CAPITAL INSIGHTS | VALUE TILT PORTFOLIO

SSgA Global Entities

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Web: www.ssga.com

The views expressed in this material are the views of Frederic Jamet through the period ended 30 November 2012 and are subject to change based on market and other conditions. The informa-tion provided does not constitute investment advice and it should not be relied on as such. All material has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Past performance is not a guarantee of future results.

The simulated performance shown was created by the SSgA Equity Index Management Unit. The results shown do not represent the results of actual trading using client assets but were achieved by means of the retroactive application of a model that was designed with the benefit of hindsight. The simulated performance was compiled after the end of the period depicted and does not represent the actual investment decisions of the advisor. These results do not reflect the effect of material economic and market factors on decision-making.

The simulated performance data is reported on a gross of fees basis, but net of administrative costs. Additional fees, such as the advisory fee, would reduce the return. For example, if an annual-ized gross return of 10% was achieved over a 5-year period and a management fee of 1% per year was charged and deducted annually, then the resulting return would be reduced from 61% to 54%. The performance includes the reinvestment of dividends and other corporate earnings and is calculated in US dollars.

The simulated performance shown is not necessarily indicative of future performance, which could differ substantially.

Investing involves risk including the risk of loss of principal.

Risk associated with equity investing include stock values which may fluctuate in response to the activities of individual companies and general market and economic conditions.

Standard & Poor’s (S&P) S&P Indices are a registered trademark of Standard & Poor’s Financial Services LLC.

Although bonds generally present less short-term risk and volatility risk than stocks, bonds contain interest rate risks; the risk of issuer default; issuer credit risk; liquidity risk; and inflation risk. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.

Investing in foreign domiciled securities may involve risk of capital loss from unfavorable fluctuation in currency values, withholding taxes, from differences in generally accepted accounting prin-ciples or from economic or political instability in other nations.

Investments in emerging or developing markets may be more volatile and less liquid than investing in developed markets and may involve exposure to economic structures that are generally less diverse and mature and to political systems which have less stability than those of more developed countries.

© 2013 State Street Corporation. All Rights Reserved. ID1889-INST-3569 1112 Exp. Date: 31/1/2014

Conclusion

Value portfolios have proliferated and now include many

well-known indexes such as the FTSE RAFI index and the

MSCI High Dividend Yield index. A typical value portfolio

exhibits the classic characteristics of value—notably a fairly

consistent overperformance against the MSCI World over the

past 20 years with a comparable level

of volatility.

It is somewhat difficult to determine what best explains their

performance; between the rational approach, where value can

be viewed as an additional risk premium, and the behavioural

approach, where value is a rational way to take profit from

noisy trading.

It appears, however, that the major part of value overperformance

occurs in stressed markets, when volatility is high or performance

is low. One interpretation could be that value is the premium

associated with the investor’s capacity to continue to hold the

value portfolio during difficult times or to support the possibility

of bankruptcy risk.