12/04/13   Changing Styles

Editor’s Corner

Ron Rowland

The definition of “style” investing has changed over the years.  We hesitate to say it has evolved, because not all the changes have been an improvement in our opinion.  Among the earliest style distinctions were the attributes defining growth and value investing.  These categories survived years of change and remain valid descriptions today.

Style by objective was the next step of the so-called evolution.  Rather than focusing on whether the investment manager followed a growth or value discipline, investors classified managers and funds as seeking capital appreciation, current income, or a combination of both.  Unfortunately, the descriptive term “capital appreciation” was shortened to “growth” somewhere along the way.  This created confusion as this “growth” was different from the original growth definition.  It was entirely possible to own a growth fund following a value approach.

The next generation of investment styles was much more descriptive, able to provide insight into the manager’s approach with just a few words.  Aggressive growth, earnings momentum, dividend growth, deep value, relative value, convertible arbitrage, and trend following were just a few of the names used to describe various investment styles.

In the early 1990s, Morningstar began heavily promoting its 9-square style-box, which became the next phase of describing investment styles.  The Morningstar approach had many good attributes, including its simplicity and ability to convey style information graphically.  The approach classifies stocks as either having a predominance of value characteristics, growth characteristics, or a combination of both.  This creates three columns, which are further divided into three rows based on large, medium, or small market capitalization.

The downside to this approach is that many managers would be penalized for “style drift” if, for instance, they moved from the Large Cap Growth square to the Mid Cap Growth category, even though their investment approach did not rely on capitalization.  A manager pursuing an earnings momentum approach, could find himself in the Large Cap Growth box one year and Mid Cap Growth or even Mid Cap Value the next.  Many investment styles are not constrained by capitalization or growth versus value designations.

Factor investing tends to focus on one key attribute, or factor.  Today there are single-factor ETFs tracking single-factor indexes that attempt to isolate and select stocks on a single criterion.  Examples include yield, volatility, size, revenue, beta, dividend growth, and buybacks.  There are also multi-factor investing styles, such as a combination of large capitalization, dividend growth, and low beta.

Indexing methodology is adapting to this new landscape.  For many years, most indexes weighted their holdings by market capitalization.  Exchange-traded funds (“ETFs”) tracking indexes are easier to bring to market, and usually less expensive, than actively managed ETFs.  As a result, new indexes are being developed to meet the wants and needs of investors and the ETF industry.  Smart Beta is the term often applied to any index not employing capitalization weighting.  Equal, single-factor, or multi-factor weighting schemes are all possible and all fall under the “smart beta” umbrella.

However, don’t let the name fool you.  These new approaches are neither automatically smarter nor better.  They are just a rules-based approach to defining an investment style.  Like all investment styles, there will be times when they are in favor and times when they are not.

Investor Heat Map: 12/4/13

Sectors

The holiday-shortened week produced little change in the Sector rankings.  Health Care remains on top and expanded its lead over second place Industrials.  Meanwhile, Consumer Discretionary closed the gap on Industrials and is mounting a campaign to reclaim the second place position.  Technology and Financials swapped positions with Technology coming out on top and placing itself in the upper tier.  Consumer Staples and Materials also swapped positions and are now aligned with Financials to form the middle tier.  The lower four categories all weakened but held their relative positions.  Utilities flipped from positive to negative momentum while Real Estate fell deeper in the red.

Styles

Micro Cap led the Style rankings for the better part of the past five months.  A few weeks ago, we started to see strength shift toward the Large Caps, causing Micro Cap to fall out of favor.  We warned it was premature to read anything definitive into the action and suggested monitoring the situation instead of taking action.  In hindsight, that turned out to be good advice as not only is the Micro Cap category at the top, it also has a significant lead over second place Small Cap Growth.  Mega Cap slipped from second to third, although it is still close enough to the top to maintain the extremism alignment we discussed last week.  In case you missed that, an extremism alignment occurs when Micro Cap and Mega Cap (the extremely small and extremely big capitalization categories) are both highly ranked while the Mid Caps are on the bottom.  The remaining categories show little change from a week ago, although they all lost momentum.

Global

China held its top ranking for the third week in a row.  Europe is still in second place although it fell further behind China from an absolute strength perspective.  The U.S. has posted momentum scores nearly identical to those of Europe for the second week running, extending this virtual tie a little longer.  World Equity, the U.K., EAFE, and Japan comprised the middle of the pack a week ago and again today.  Canada was formerly in that pack but lost enough momentum to put in on the verge of flipping to a negative trend.  Weakness in the Canadian dollar and the Energy sector are to blame.  Emerging Markets climbed one spot, but it is barely clinging to a positive score.  Pacific ex-Japan was not so fortunate, flipping over to red this week.  Latin America was the weakest performing category, increasing the magnitude of its negative trend.

Note:

The charts above depict both the relative strength and absolute strength of various market sectors, styles, and geographic locations on an intermediate-term basis. Each grouping is sorted (top to bottom) by relative strength. The magnitude of the displayed RSM value is a measure of absolute strength, which is our proprietary method of measuring and reporting the intermediate-term strength as an annualized value.

 


“In fact, while we know that style-specific funds have their charms, we acknowledge that flexible funds also have advantages.”

Morningstar.com Investing Classroom, Course 404


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