Academic journal article Financial Services Review

Choosing between Value and Growth in Mutual Fund Investing

Academic journal article Financial Services Review

Choosing between Value and Growth in Mutual Fund Investing

Article excerpt

1. Introduction

The well-known value premium argues that value securities, securities with high bookto-market ratios or low price-to-earnings ratios, outperform other securities when raw returns or returns adjusted only for market risk are considered. There is a substantial literature to support this finding, beginning with Basu (1983) studying the relationship between priceto-earnings ratios and returns, and with Rosenburg, Reid, and Lanstein (1985) studying the relationship between book-to-market ratios and returns. These results have been confirmed in numerous other studies including the discipline-altering study of Fama and French (1992). Not only has the value premium been persistently reported, it is also large. From July 1926 through December 2012 this premium has averaged an annualized value of 6% based on data from Kenneth French's Web site.

Because of the strong evidence of outperformance by value securities, individual investors and financial planners may wish to consider a preference for value mutual funds relative to growth mutual funds. Indeed, writing in Forbes, Clash (1998) argues that investors interested in small-company stocks should invest in small-company value mutual funds on the basis of the superior performance of the Russell 2000 Value Index versus the Russell 2000 Growth Index. Clash suggests that small-firm investors might use index funds to operationalize his recommendation.

Two cautions may be appropriate for financial planners and individual investors considering Clash's recommendations. First, the component stocks in the index funds do not perfectly match the component stocks of the portfolios formed in empirical studies that provide evidence of a value premium. Second, superior performance by an index of value stocks relative to an index of growth stocks does not necessarily indicate superior performance by managed value funds relative to managed growth funds, and many individual investors and planners prefer to invest in managed funds.

Empirical studies heighten the concern that managed value funds might not display the superior performance suggested by the value premium. Piotroski (2000) reports that the value premium results from a subset of value securities and that most value securities underperform the market. Piotroski suggests that with the use of readily available accounting information one can identify those value securities that will outperform.1 However, are managers of value funds successful in identifying those value securities that will outperform? Extant studies comparing the performance of value and growth mutual funds estimate α using the Fama-French three-factor model and conclude that growth funds outperform value funds. This finding suggests the inability of value fund managers to identify those value securities that will outperform.

In this article, however, we present new empirical evidence supporting the presumption that investors may exploit the value premium through mutual fund purchases especially for small-firm funds and index funds. Our conclusion is, in large part, driven by the lower realized risk of value fund portfolios. We argue that previous finding of superior performance of growth funds results from a bias in estimating mutual fund αs using the three-factor model.

In the next section we discuss the findings of previous studies on the relative performance of value and growth mutual funds. In Section 3, we describe our sample and methodology. We present empirical results in Section 4 in three parts: first, we compare traditional risk and return measures; second, we examine the implications of these results for an investor's end wealth, finally, we reconcile our results with previous studies. In the final section, we offer our conclusion.

2. Previous studies

A considerable literature seeks to inform investors on choices relative to the wide array of mutual fund investment opportunities. Most of the literature concentrates on measuring the ability of mutual fund managers to "beat the market," to earn a return greater than justified by the mutual fund's risk. …

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