The authors investigate the source of outperformance of value over growth investing and
determine that it is a side effect of routine portfolio rebalancing. They illustrate the
paradox of rebalancing: It can have diametrically opposite effects to help (value) and
hurt (growth) performance.
Drawing a crucial distinction between investment performance effects specific to individual
stocks and those specific to portfolios, the authors emphasize a novel contrast when
examining growth versus value. Namely, after decomposing portfolio returns into three
factors—changing valuation, dividend income, and dividend growth—they show that
although the valuation factor has varying effects, value-focused portfolios dominate growth
on both of the other two components.
They attribute this surprising finding regarding the dividend growth factor (i.e., value
portfolios have consistently superior dividend growth results) to portfolio rebalancing.
This customary annual adjustment consistently and strongly undercuts any theoretical
advantage claimed by growth stocks, persists for at least five years after the rebalance,
and is widely observed in the United States and many other developed markets.
How Is This Research Useful to Practitioners?
For equity investors, the authors’ findings can be provocative because they also
address alternative explanations by prominent theorists who attribute value outperformance
either to extra financial risk bearing (Fama and French) or errors in extrapolating earnings
growth (Lakonishok, Shleifer, and Vishny). Rather than blaming investor misperceptions, the
authors argue that the requisite steps to maintaining an investment discipline and
consistently following one’s strategy (value or growth) affect the underlying return
drivers (e.g., the dividend growth component) and, therefore, the ultimate results. And with
some irony, this result is a consequence of the interplay between investor types because
growth holders pare back their holdings with decelerating earnings by selling them to value
This observed rebalancing effect also holds for the market portfolio; indexing to maintain
it appropriately (e.g., the top 1,000 stocks ranked by market capitalization) will reduce
its dividend-related return components, although not as significantly as it will for pure
growth portfolios. The authors also identify rebalancing’s influence on popular
current alternative index strategies, such as equal weighting, diversity weighting, maximum
diversification, fundamental weighting, and minimum variance. Parenthetically commenting on
the optimality of these indexing strategies, the authors note the suitability of each of
them for different types of investing, whether it is growth, value, or capitalization
How Did the Authors Conduct This Research?
The study is based on two samples and covers U.S. data for 1963–2010 and
international data for the 23 countries in the MSCI developed markets ex-U.S. portfolio for
1983–2010. Monthly total and price returns are from CRSP. From a universe of the 1,000
largest stocks—excluding companies without book value data—the authors assign
the top 50% by market capitalization to the value portfolio and the remainder to the growth
portfolio, which splits in half the third portfolio examined (the market portfolio). All
portfolios are capitalization-weighted annually and followed with a six-month lag, with
calendar year-end rebalancing to derive annual total and price returns from monthly
compounding. They decompose the total returns into the three subclasses of return sources:
changing valuation, dividend income, and nominal dividend growth. Dividend growth is further
segmented into its trends both before and after rebalancing.
The authors track the contribution to total returns from the three components over time for
the market, value, and growth portfolios, as well as the impact of rebalancing, to cover
both U.S and international results. They then use, with a further retrospective review of
the study’s variables, the Fama–French size and book-to-market portfolios to
assess a 1928–2010 data series. They also examine the three-part return components for
popular indexing strategies over the period 1964–2009.
By illuminating the potentially substantive effects of a routine, nonjudgmental aspect of
portfolio management—annual rebalancing—the authors put a fairly ingenious
historical revisionism on a classic question of equity investment: Which is best,
growth or value? It can give growth managers pause, with the right to lament that
“the fault is not in our stars, but in ourselves,” that by simply doing the
mechanics, these managers battle headwinds vis-à-vis their value rivals. And the
authors raise the intriguing possibility that rebalancing alphas may extend across all types
of markets and their related strategies/indices.