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Triumph of style over content

Whether a portfolio is tilted towards value or growth, or a blend of the two, investment style can make a big difference to its performance.

Style is one of the four most important sources of risk and return for investors, the others being country, sector and stock.

If you invest in a pooled vehicle such as a unit trust, you leave the choice of sectors and stocks to a fund manager. But should you consider the question of which countries and which style to plump for?

Recent research by Schroders&#39 investment strategy unit shows it is not enough simply to rely on switching from one sector to another in order to achieve the best returns. The influence of which country you are invested in and which style dominates your portfolio can be as great, if not greater.

The study found that, in Europe, a deliberate bias towards one style or another is more important than a decision over which country to invest in and as crucial as being underweight or overweight in a particular sector.

During the period to the end of March 2000, when technology dominated most markets, you would expect the effect of sector to overshadow that of country. It did. Unexpectedly, however, the study found that the choice of investment style carried an equal weight to that of sector.

The study demonstrates that style is a key part of any investment decision, particularly for those constructing an international portfolio. Style is an important source of return that investors ignore at their peril.

Many investors, particularly those taking active decisions based on the best advice available, are implicitly considering style. They may be interested in so-called value stocks, which are priced below the market average, in the belief they will recover in value or they may choose growth stocks whose sales or earnings are expected to grow rapidly and so are highly priced.

At its simplest, style investing is a way of controlling the exposure in an investment portfolio – in other words, of tilting it towards value, growth or a blend of the two – while continuing to benefit from a fund manager&#39s ability to pick stocks to match his or her style. If style is an important source of risk and return, what drives it?

The short answer is that investment style is made up of a number of characteristics, each of which can be influenced by different things. Take value stocks. Typically, value stocks have tended to do well after a recession when interest rates are falling – conditions that signal a likely recovery in economic growth.

But different types of value stocks react in different ways across markets. Stocks that fall into the category of relative value – those that are cheap compared with their own history – have tended to perform well in the US over the long term. But in continental Europe, stocks of absolute value – those that are cheap compared with the average for the market – tend to perform more strongly.

Subtle patterns exist for growth stocks, too. Stocks with a history of strong growth in profits and share prices over at least a year – a characteristic we call recent growth – have performed strongly in most major markets over the past 15 years or so.

Such stocks do less well as the economy recovers. By contrast, stocks described as trend growth – those with a track record of three years or more – tend to be defensive in nature. These are invariably good to have on your side when interest rates begin to rise. Of course, these are not hard and fast rules, merely characteristics that have been back-tested and seem to hold good most of the time.

Understanding trends of this kind is vital for managers running money internationally. If you are trying to construct an international portfolio, it is important to know what you have to do in order to beat different benchmarks in different markets. To help fund managers become more consistent in meeting their targets, Schroders has developed tools that analyse these trends.

One such is the Risk Analyser. This examines the portfolios of our retail funds and flags potential concerns if it sees them. The Risk Analyser takes a balanced view, recognising, among other things, that an overweight position in technology is riskier than one in financials. Information of this kind is useful in establishing whether a fund is meeting its objectives and what is driving its performance.

Another tool is the Stock Book. This examines portfolios in terms of style characteristics. Not only does it measure a fund to determine whether it is what it says it is – active value, dynamic growth or a blend of the two – but for all the major markets it also examines the contribution of the different characteristics to performance over different periods of time.

Of course, fund managers in particular regions often tend to favour a particular approach. Those investing in continental Europe, for example, place more store on sectors while those running money in Asia tend to focus more on the country. Such bias may be legitimate in that, from experience, managers know what works best for their patch. What is important is that they recognise that other characteristics also have an influence.


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