Investing in diversified portfolios involves consideration of valuation-based and capitalization-based styles. In this article, we will look at some basic elements of style investing and examine the phenomenon of apparent systematic anomalies, such as the value effect and the small-cap effect, that are well documented in portfolio management. Finally, we will provide some basic how-to advice on the construction and maintenance of a style-based portfolio.

What Is Style Investing?

"Style" refers to asset groups within a broad category (such as equities or fixed income) that display similar fundamental characteristics. The two most common equity style measures are valuation and capitalization. Valuation divides stocks into value, growth and core. Value is characterized by low valuation multiples like price to book (P/B) and price to earnings (P/E). Growth companies are believed to have higher-than-average sales and earnings growth prospects. Core is a blend of value and growth.

For example, Russell Investments operates a series of style indexes with two valuation measures: the P/B ratio (the Institutional Brokers Estimate System (I/B/E/S) medium-term forecasted growth estimate (two years), which is a compilation of earnings estimates provided by investment analysts from more than 850 global investment organizations) and sales per share historical growth. These variables are combined into a composite value score, based on which 70% of the stocks are classified as all-defensive or all-dynamic, with the remaining 30% in either the growth or value index.

The other traditional equity style is market capitalization. Russell, by way of example, ranks 4,000 publicly traded U.S. companies as follows: The Russell 1000 Index contains the top 1,000 stocks by market cap, the Midcap Index is made up of the 800 smallest names in the Russell 1000, and the Russell 2000 Small Cap Index features stocks with market caps that rank them from 1,001 to 3,000. At the bookends of the capitalization spectrum are the Russell Top 200 Index of mega-cap stocks and the Microcap Index (3,001 to 4,000).

Does Style Matter?

Style and Asset Allocation
Style is integral to many asset allocation strategies and is a key element of modern portfolio management. Studies conducted over the years show that asset allocation is a significantly more important attribute of portfolio performance over time than, say, individual investment selection or market timing. For example, the widely-known Brinson Hood Beebower study, "Determinants of Portfolio Performance" (Financial Analysts' Journal, 1986), showed that 93.6% of performance was due to allocation attribution.

Asset allocation involves a risk decision -- the mix of equities, debt and alternative assets, based on an investor's particular risk tolerance -- and a style decision, or the mix of value, growth, large- and small-cap and other style types.

The Curious Case of Style Effects
Over the years, certain styles appear to exhibit persistent outperformance over long time periods. Perhaps two of the most well-known of these so-called style effects relate to value stocks and small-cap stocks. For example, James O'Shaughnessy's book, "What Works On Wall Street," which was originally published in 1996, documents portfolio performance back to 1963 and affirms both the value effect and the small-cap effect. O'Shaughnessy published a follow-up article in 2007 where he noted, with some apparent bemusement, that despite the amount of literature written and published about these effects, they appeared to be as intact as ever; in other words, the outperformance had not been arbitraged away as we might expect.

The chart below shows total annualized returns for four styles over a 34-year period from 1979 to 2013, as measured by the Russell indexes. The Russell 3000 Value and Growth are all-cap valuation style indexes while the Russell 1000 and 2000 are all-valuation capitalization style indexes.

Copyright © 2013 Sources from Zephyr Associates, Inc

The results appear to show evidence of a value effect, as well as a more modest small-cap effect. Over the 34-year period, value stocks outperformed their growth counterparts. Small cap stock indexes, like the Russell 2000, returned slightly below than the large-cap Russell 1000 and the S&P 500.

The really interesting thing about this chart, though, is that value's outperformance was achieved with significantly lower risk (standard deviation). This runs counter to the commonly accepted notion that high return equals high risk. The somewhat bizarre evidence shown here and in other value effect studies seems to be the capital market equivalent of a free lunch.

The Psychology of Style
How can a supposedly efficient capital market persistently reward a particular style this way? One answer comes from practitioners of behavioral finance. They argue that human emotions influence investment decisions and lead to systematic, seemingly illogical, outcomes. The value effect, according to the behaviorists, comes about because investors are emotionally attracted to the allure of growth stocks as a result of the greater amount of attention and media coverage growth stocks receive compared to value stocks. Ultimately, this contributes to the decision to invest in these rather than in cheaper, more boring stocks. In other words, human emotion gets in the way of rational value maximizing and keeps these anomalous effects from self-correcting, as we might assume they would.

The Practice of Style Investing

Constructing a style portfolio is relatively straightforward. The first thing to do is to allocate weights to each style -- generally following the "style box" approach used by Russell, Morningstar and others -- along a 3x3 matrix of value, blend and growth on one axis and large-, mid- and small-cap along the other:

Copyright © 2007

Style weighting is a means to act on specific views, such as a value bias or a higher small-cap weighting, for example.

Let us look at a hypothetical example below. For the sake of simplicity, we will restrict our example to four style groups: large-cap value (LCV), large-cap growth (LCG), small-cap value (SCV) and small-cap growth (SCG).

  • Style A: Equal-weighted: LCV 25%, SCV 25%, LCG 25%, SCG 25%
  • Style B: Value bias: LCV 35%, SCV 35%, LCG 15%, SCG 15%
  • Style C: Small-cap bias: LCV 15%, SCV 35%, LCG 15%, SCG 35%
  • Style D: Value & small-cap bias: LCV 30%, SCV 40%, LCG 10%, SCG 20%

Once the style weights are determined, the next step is to choose a means of exposure, bearing in mind that indexes are not directly investable. There are many passive index funds and exchange-traded funds (ETFs) that mirror the performance of equity style indexes.

For the above four styles, we have selected four Barclays iShares ETFs as our means of exposure. The iShares Russell 1000 Value Index (IWB) is a proxy for the Russell 1000 Value, which is a large-cap value index; the same goes for the iShares Russell 1000 Growth (IWF), which is a large-cap growth index; the Russell 2000 Value (IWN), which is our small cap value index; and Russell 2000 Growth (IWO), which is our small-cap growth index.

The table below shows the backtested performance (total annualized return and standard deviation) of these four style portfolios over the period Aug.1, 2000 (the inception date of the iShares ETFs) through July 31, 2007.

Period: Aug. 1, 2000 - July 31, 2007 Portfolio Performance
-- Annualized Return (%) Standard Deviation (%)
iShares Russell 1000 Value (IWB) 8.29 12.26
iShares Russell 1000 Growth (IWF) -4.18 18.00
iShares Russell 2000 Value (IWN) 13.59 15.69
iShares Russell 2000 Growth (IWO) 1.18 22.66
-- -- --
Style Portfolio A: Equal Weighted 5.20 15.47
Style Portfolio B: Value Bias 7.60 14.39
Style Portfolio C: Small-Cap Bias 6.28 16.46
Style Portfolio D: Value & Small-Cap Bias 8.13 14.89
Source: Zephyr & Associates LLC StyleAdvisor

For this period, both the value effect and the small-cap effect are evident. Portfolio D, with both a value and a small-cap weighting, achieves an average annual return that is nearly 3% higher over this period than the equal-weighted Portfolio A and with less volatility.


All of the style portfolios in the above example are rebalanced annually. Over time, actual portfolio weights will change according to the relative performance of each asset class, with outperformers gaining shares and underperformers losing their proportional representation. Rebalancing is the action of selling off winners and buying losers to restore the original target weights. Typically, a manager will rebalance on at least an annual basis and sometimes more frequently. Asset allocation practitioners refer to rebalancing as the discipline that keeps a strategy intact over a long time period.

Active style managers often take advantage of the rebalancing exercise to reallocate style weights. If done frequently -- say once a quarter -- this is called tactical asset allocation, as the manager seeks excess returns from his or her cyclical views on asset class performance. For example, style managers who shifted into large- and mid-cap growth during the tech boom of the late 1990s improved their performance, while managers who increased weightings in small-cap value during the 2003 to 2006 period also enjoyed cyclical outperformance.

Finally, style classes are not static. A large-cap value or small-cap growth stock does not stay that way forever. Valuation multiples and market caps change every day. For example, a small-cap value stock that comes into favor may increase rapidly in price. As the price goes up, all else being equal, the P/B and P/E ratios will tend to increase and, subsequently, so will its market cap. So, today's small-cap value stock may become tomorrow's large-cap growth stock, and vice versa. Style managers will pay close attention to this "migration" between value and growth, large- and small-cap as they refine and rebalance their portfolio exposures.

The Bottom Line

Style is a fundamental component of portfolio management. We have seen that over time, stocks with similar style characteristics based on valuation and capitalization measures exhibit distinct return and risk performance. Style investing is one of the major components of asset allocation strategies. In addition, studies conducted over a long time period have shown evidence that value stocks -- those with relatively low value multiples -- have outperformed their peers with higher multiples, and also that small-cap stocks have tended to do better over long time periods than large-cap. A style portfolio can allocate weights to reflect an investor's views on the performance of different style classes over a long-term (strategic) or cyclical (tactical) time period.

Want to learn how to invest?

Get a free 10 week email series that will teach you how to start investing.

Delivered twice a week, straight to your inbox.