Scientific Beta

This paper explores value investing and its potential for long-term outperformance, presenting the Scientific Beta Value index as a refined strategy that incorporates intangible capital in our definition of value firms and stabilizes market exposure.

Value investing offers the potential for long-term outperformance over the broad equity market. A large body of academic literature provides evidence that high-value firms earn higher long-term average returns than low-value firms. Consequently, many investors pursue value investment strategies. The Scientific Beta Value index offers a refined approach to implement such a strategy. The two main features of our approach are that we incorporate intangible capital in our definition of value firms and stabilise the market exposure of our strategy.

A first key question for value investors is how to define a value firm. We use the intangible-adjusted book-to-market ratio to select value stocks. This definition is in line with the book-to-market ratio proposed by the academic literature and accounts for intangible capital, which is increasingly critical in the current economy. Including intangible capital improves the performance of our value strategy and ensures alignment with the economic mechanism behind the value premium. Furthermore, we also exclude value traps - value stocks with undesirable features like low quality or negative momentum - from our stock selection.

Value strategies can have market betas that deviate from one and vary over time when left uncontrolled. Variability in market beta means that the tracking error of a strategy is partly driven by implicit bets on market performance over short horizons. The weighting scheme of our value index includes a mechanism that targets a stable market beta of one. As a result, the undesirable tracking error component introduced by market beta deviations is reduced and relative performance is driven by the value tilt.

These index design features deliver robust performance across regions. During our sample period, our value index delivered a relative return over the market index of 1.5-1.8%, with a comparable level of volatility. Such results are driven by our selection of firms with a low valuation relative to their physical and intangible capital. The stable market beta around one avoids unnecessary tracking error. Figure 1 highlights how our index design features work together to deliver strong long-term returns, with a cumulative outperformance over the cap-weighted market index of around 160% over the past forty years.