We have seen that the newer generation of factor indices have shown strong outperformance over the past 20 years. That makes them interesting for investors to look at when selecting the right strategy.
But are there ways to narrow the choice down even more?
As it turns out, not all factor indices are created equal. Indeed, the disparities in returns across the same factor styles can be substantial, as we found when we analyzed all the value factor indices tracked by ETFs in Europe.
Here, the MSCI EMU Prime Value delivered excess returns of some 500 basis points per annum over the last two years, a substantial outperformance against its value peers.
Why does this particular value index perform so well?
One reason is its overall approach. The Prime Value concept is to select relatively "cheap" stocks, but only from a universe of higher quality ones – in other words to select good quality companies that are undervalued, perhaps due to investors' biases or other constraints. Such true bargains offer the possibility of better risk-adjusted returns.
Prime Value uses a quality filter aimed at limiting its exposure to companies that are "cheap" due to their poor financial health or macroeconomic risks, in which case the price discount primarily represents risk compensation.
This approach historically worked quite well. The Prime Value methodology succeeded at creating indices of stocks with lower valuation (P/E) but higher quality (higher RoE) relative to parent indices.
This is something investors might want to factor into their decisions.