Rebalancing and the Value Effect

Abstract

It is amply documented that a value portfolio outperforms a growth portfolio over long spans in most markets worldwide. Less well known, however, is how this outperformance is achieved. Decomposing the total returns of these strategies, we find that (a) value portfolios enjoy higher dividend income and (b) the average growth stock enjoys faster dividend growth than the average value stock; but, surprisingly, (c) value portfolios experience higher growth in dividends than growth portfolios. We argue that the first two findings are expected, but the third one is not completely understood by investors. This third result is a consequence of the nature of the rebalance rules for growth and value portfolios. Each rebalance replaces lower-yielding value stocks with new higher-yielding replacements, and replaces higher-yielding growth stocks with new lower-yielding replacements. It is, therefore, the act of rebalancing and reconstituting the growth and value portfolios that increases the growth rate for dividend income in value strategies, and rather sharply reduces it in the case of growth strategies. While this is analogous to the findings of Fama and French in their Migration paper, our results more specifically attribute much of the advantage of value strategies to the acts of reconstituting and rebalancing and their side effects on dividends. In so doing, we shed some light on the faster dividend growth of value portfolios.