Value Investing Meets Factor Strategies: Beyond Plain Vanilla Investing

For Canadian investors seeking a disciplined, evidence-based approach, index-driven factor investing may offer a compelling alternative to purely passive management.

Factor investing is a strategy that targets specific, well-documented characteristics or “factors” that explain the risk and return of securities across asset classes. These factors are intended to help investors identify securities likely to outperform over time, based on structural inefficiencies in the market.

The earliest widely adopted framework was the Capital Asset Pricing Model (CAPM), developed by William Sharpe and others in the 1960s, which focused on a single factor: market beta. This was later expanded by Eugene Fama and Kenneth French, whose three-factor model incorporated two additional drivers of equity returns: size (small-cap stocks tend to outperform large-cap stocks) and value (stocks that are cheap relative to fundamentals tend to outperform expensive ones).²

Since then, academics and practitioners have identified additional equity factors, leading to what some refer to as the “factor zoo”, a broad set of strategies based on characteristics such as momentum, quality, low volatility, and profitability³. While not all proposed factors have withstood rigorous testing, several core factors have proven persistent, pervasive, and robust across different markets and time periods.

The value factor refers to the historical tendency for stocks that trade at lower valuations — such as low price-to-earnings or low price-to-book ratios — to outperform more expensive “growth” stocks over time. This concept is at the heart of value investing, which seeks to target fundamentally strong but undervalued companies.

However, the value factor and value investing are not interchangeable. That said, they are closely connected. Using a value approach to actively select undervalued stocks means that your portfolio will likely have higher exposure to the value factor. Using the value factor specifically to select or weight securities in a portfolio will do the same, but in a more systematic and rules-based way.

Although value has experienced long stretches of underperformance, particularly during the post-2008 bull market dominated by growth and tech stocks it has historically shown mean reversion tendencies. Periods of economic uncertainty, rising interest rates, or inflation often see value stocks regain leadership, reinforcing the long-term case for maintaining exposure to the value factor.⁴

Passive factor ETFs are built to track indexes that systematically select and weight securities based on specific factor criteria – like value, quality, or momentum. The appeal? These ETFs are intended to tap into the benefits of active insight such as buying undervalued or high-quality stocks without the costs or behavioral pitfalls often associated with traditional active management.

The CI U.S. Enhanced Value Index Fund for example, tracks an index that takes a multi-faceted approach to the value factor. Rather than attempting to time the market or pick winners based on macro forecasts, passive factor ETFs seek consistent exposure to these long-term drivers of return.

A typical value index usually relies heavily on a single metric like price-to-book or price-to-earnings. CVLU, however, tracks the VettaFi U.S. Enhanced Value Index*, which uses a comprehensive, rules-based process. It scores U.S. large- and mid-cap companies across five distinct valuation metrics, incorporating both current and forward-looking data:

• Book-to-price
• Earnings-to-price
• Sales-to-price
• Dividend yield
• Free cash flow yield (forward-looking)

This multi-metric approach results in a composite value score for each stock, intended to give investors a more holistic measure of relative value than single-metric models.

CVLU starts with a universe of 1,000 large and mid-cap U.S. stocks (based on the VettaFi U.S. Equity Large/Mid-Cap 1000 Index). From there, the process unfolds as shown in the graphic below:

The methodology incorporates both forward-looking and backward-looking data, which seeks to provide a more nuanced assessment of a stock’s valuation. From there, the index selects the top 100 securities from a universe of the largest 1,000 stocks in the U.S. market based on their composite value scores. The chosen stocks are weighted by a combination of value score and market capitalization. Rebalances occur semiannually, which helps the fund maintain its desired factor exposure.

This structured approach aims to allow investors to access value investing principles in a disciplined, cost-efficient manner. The result is a strategy which seeks to be resilient across market cycles, without relying on guesswork or tactical shifts.

1) A Primer on Factor Investing, Ilya Kulyatin, May 6, 2022, https://medium.com/@ilya.kulyatin/a-primer-on-factor-investing-d00d1914eaf6
2) The Cross-Section of Expected Stock Returns, Eugene F. Fama, Kenneth R. French, The Journal of Finance VOL XLVII, NO 2, June 1992, https://www.ivey.uwo.ca/media/3775518/the_cross-section_of_expected_stock_returns.pdf
3) . . . and the Cross-Section of Expected Returns, Campbell R. Harvey, Yan Liu, Heqing Zhu, April 20, 2015, https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2249314
4) Value and Momentum Everywhere, The Journal of Finance VOL. LXVIII, NO. 3, June 2013 Clifford S. Asness, Tobias J Moskowitz, and Lasse Heje Pedersen https://pages.stern.nyu.edu/~lpederse/papers/ValMomEverywhere.pdf

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VettaFi LLC (“VettaFi”) is the index provider for CVLU, for which it receives an index licensing fee. However, CVLU is not issued, sponsored, endorsed, or sold by VettaFi or its affiliates, and VettaFi and its affiliates have no obligation or liability in connection with the issuance, administration, marketing, or trading of CVLU. VettaFi LLC is an affiliate of TMX Group Limited.