One of the first practical lessons in investing is that a well-constructed portfolio means one that is appropriately diversified. The standard form of diversification is through combining asset classes - such as bonds and property funds - with equities. However, this is not necessarily enough to reduce or optimize portfolio volatility. Diversification by management style is often the missing link in getting the right mix.
What exactly is investment style?
In this investment context, a style can be defined as the method that managers use to buy stocks or other assets. Newcomers to the investment business are often surprised at the very considerable variation and latitude in style and its powerful impact on performance at a given time and over a period of time. (For related reading, see Focus Pocus May Not Lead To Magical Returns.)
According to Shawn Menard, writing in the Canadian Investment Review ("Risk Management: A Dynamic Process", 2000), this remains an underrated but extremely useful means of spreading risk. The deliberate use of variations in investment style as a means of reducing volatility is gaining considerable acceptance in the investment world; many believe that a symbiotic blending of management styles is an important part of the diversification process.
So-called "style rotation" has arguably become even more important in the new millennium, as the conventional equity-bond split has lost effectiveness through global capital market integration. Stylistic differences between money managers lead to a low correlation between or within asset classes that are managed with varied approaches. This is extremely valuable at a time when globalization tends to iron out differences between asset classes and many international markets are increasingly moving in tandem.
Offers and Guarantees of Style Diversification
Several investment advisory firms from around the world have developed plans to diversify their clients' portfolios across asset classes, within asset classes and across investment management styles. In the same way that different asset classes perform better and worse at different times, so too do varying approaches to management within these asset classes.
Some major university endowment funds specify diversification in terms of style and guarantee to hire a certain number of managers with varying styles. The University of Missouri, for instance, promises a minimum of five separate managers, providing "different and complementary strategies of equity investing". The objective is "to ensure the absence of either under- or over-exposure to particular style approaches." (For more insight, read How do university endowments work?)
The Main Styles
Value and Growth
The two classic stock-picking styles are those of value and growth. The value style entails buying stocks that are regarded as cheap, whereas growth stocks are expected to grow faster than the rest of the market. These two basic methods are quite different and, by having funds with both styles, investors are able to enjoy the best of both worlds. Particularly over the longer term, investors are likely to find that volatility can be reduced by mixing investment styles. (For more on these styles, read Warren Buffett: How He Does It and Venturing Into Early-Stage Growth Stocks.)
Apart from these two classics of value and growth, there are several other fundamentally different approaches to the market. The momentum strategy is one. The idea behind this approach is that investments that have been doing well in the past and have gathered "momentum" are likely to continue doing well. Of course, it is necessary to figure out when the momentum will slow down or come to a halt. (To continue reading about this approach, see Riding The Momentum Investing Wave.)
Another form of style is the relative emphasis on market capitalization - small-, medium- or large-cap stocks. By shifting the allocation toward one size of company and away from another, very different results and performance can be obtained. In the extreme, small caps may be doing really well as a whole, while their big brothers take a loss. This is what diversification is all about. (To read more, see Market Capitalization Defined.)
Top-Down and Bottom-Up
Another important stylistic differentiation is between top-down and bottom-up approaches. The former entails looking at the "big picture", or the broader economic and financial scenarios, both locally and internationally, and only then moving "down" to consider specific sectors and, finally, the stocks of specific companies. Bottom-up is the opposite approach, where the focus is first and foremost on individual stocks. The basic assumption here is that good companies and their equities will thrive, even if market conditions are not particularly favorable. (For more insight, see Where Top Down Meets Bottom Up.)
The quantitative approach is another possibility, and it relies heavily on computers for mathematical and statistical modeling. The idea is to remove all emotions from the process and have a computer check through enormous amounts of data to discover unrealized asset potential. This is, therefore, a purely technology-based means of stock picking or of asset selection. There is no shortage of such methods, but in the emotion-laden markets, which still depend heavily on people and their perceptions, computers have their limitations. (To read more, see Getting To Know Stock Screeners.)
Keeping an Eye on Styles
As is the case with other assets classes and sectors, rebalancing between investment styles also makes a lot of sense. It is important to monitor and evaluate whether your style mix is performing optimally and to change it where appropriate. In other words, style should be treated like any other asset that evolves over time.
It is not uncommon for managers to not always remain true to their styles. For this reason, it is also necessary to monitor how closely managers adhere to their stated styles.
There are many way of diversifying a portfolio. One of these is through combining funds that operate according to fundamentally different investment styles. Although most people think of diversification as combining asset classes, similar or better results can be achieved though a sensible mix of value and growth stocks, bottom-down and top-up approaches, and so on.
The object of diversification is to achieve a good rate of return at an acceptable level of risk. Precisely this can be achieved by accepting and operating on the fundamental reality that asset management in the broadest sense, and not just the choice of assets, is critical.
Furthermore, whatever approach is favored, it is important to note that different styles may work better at different times, within different market structures and with different managers. Portfolios can be optimized through exploiting these differences through actively monitoring and mixing styles according to the prevailing situation in the various investment markets open to you.