Investing in diversified portfolios involves consideration of risk tolerance and style characteristics with an eye on systematic changes affecting investing opportunities in the landscape overall. In this article, we will look at some basic elements of style investing and examine some basic styles. We will also take a look at some systematic anomalies that can be important for all types of investors to be aware of.
What Is Style Investing?
Style investing typically first begins with an investors risk tolerance. Risk tolerance is usually a guiding motivation behind a portfolio’s investing regime. Generally, younger investors will often have the latitude to take on higher amounts of risk while older investors steer toward lower risk investing. Regardless all types of investors seeking to build a model portfolio with style investing will want to establish some ratio proportions. This can sometimes be easily done with funds that holistically manage for a balanced allocation like 60/40, 20/80 and so on or a fund with a strategic allocation that comprehensively meets a specific goal. Many do it yourself (DIY) investors however choose to define these ratios on their own with more flexibility for building their own comprehensive portfolio over time.
With an established risk tolerance investors can delve deeper into style quadrants for their own diversified portfolio. At this more granular level "style" often refers to groups within a broad category (such as equities or fixed income) that display unique characteristics. (See also: Investment Style ). Morningstar created the style box as a basis for helping retail investors in DIY style investing. The evolutions and use of the style box led to some distinctly characterized styles. In equities these styles include large, mid and small caps, overlaid with value, blend and growth. In fixed income Morningstar style box quadrants divide up by maturities overlaid with high, medium and low credit quality. These quadrant variables help to form the basis for style investing but there can also be more or sub-segments thereof.
Does Style Matter?
Risk based style investing gives investors the flexibility to choose from an array of investing opportunities within their rations. Style is integral at a comprehensive asset allocation level and a granular level and is a key element of modern portfolio management. Studies conducted over the years show that asset allocation can be a significantly more important attribute of portfolio performance over time than, say, individual investment selection or market timing – thus the importance of an established ration. (See also : Brinson Hood Beebower study, "Determinants of Portfolio Performance" (Financial Analysts' Journal, 1986) which showed that 93.6% of performance was due to allocation attribution.)
Value is a style that is often characterized by low fundamental ratios and high dividend yields. Benjamin Graham, the godfather of value investing, suggested that value investors stick to stocks with PE ratios of below 17. Value investing is often paired with the moderately conservative investor who wants to obtain higher returns from the stock market over time with the least amount of risk. Value investing also often overlays with income style investing which seeks high levels of income across multiple investment security types. As more established, stable businesses with steady revenue, income and cash flow, value companies usually offer the benefit of management’s commitment to dividends.
Value stocks also often tend to outperform in volatile or deflating equity market environment. This is because they have more rational valuations with a strategy that has navigated through the test of time. Many active DIY investors will often shift more heavily to value stocks in bearish markets to maintain their wealth through rough market downturns.
Growth stocks often perform the best when an economy is booming. High gross domestic product growth is often a parallel to growth stock performance. When an economy is growing their can be several factors which all lead to an environment that is conducive to new product innovation, consumer demand and growth.
The Practice of Style Investing
Constructing a style portfolio is relatively straightforward. The first thing to do is determine an asset allocation balance. Then within these buckets allocate investments using the "style box" approach.
If your portfolio is heavily weighted toward equity you can choose between single stock investments, funds or a combination of both. In equities you will want to watch a stock’s beta and a fund’s Sharpe ratio. Both of these measures are statistical metrics that help an investor to evaluate and compare risk.
Fixed income investing often provides the advantage of lower risk with steady income. In this asset class overall credit quality investing will typically show many of the same trends as in the equity market as companies are evaluated based on their financial statements and debt levels. However, investing across maturities can require a little more skill and monitoring. In the fixed income market duration is an important risk metric as it provides the amount an investment’s value will fall per percentage change in interest rate level. Thus, in rising rate environment it can be better to stick with shorter maturities.
For investors managing their own portfolios the risk environment can often be an important trend to follow. Equities tend to deflate in rising rate environments and gain in low rate environments. Rising rates and inverted yield curves with short term rates higher than longer term rates are also usually signs of a slowing economy or recession.
Trading and Rebalancing
Style may also be dictated by an investor’s trading and rebalancing preferences. High frequency traders may have the advantage of identifying and capitalizing on short term market trends. Low frequency traders however may choose to use scheduled rebalancing time periods in their portfolio investing. Regardless choosing a rebalancing schedule can also be an important factor for style investing. Staying aware of the market environment can often be helpful in a rebalancing schedule. This will typically require an investor to follow how interest rates are being managed. After the financial crisis, from 2008 to 2015, the Federal Reserve reduced the federal funds rate to zero in 2008 and held it at zero for seven years. Since 2015 the Federal Reserve has increased the fed funds rate from zero to 2.25%. With more interest rate increased expected the environment in 2019 may lend itself to more frequent rebalancing.
Rebalancing is also important for preventing style drift. Assessing the percentage allocation across all styles in a portfolio on a regular basis is also important. From 2008 to 2015, the Nasdaq soared gaining 109%. While these gains were beneficial to technology investors, they also led to technology overweights that were important to manage through rebalancing. Rebalancing to sell off some winners and invest in other areas is beneficial for following target weights. Finally, style classes are not static. A large-cap value or small-cap growth stock does not stay that way forever. Thus, rebalancing can also help to maintain awareness of market changes to particular style allocations of a total portfolio. Overall investing circumstances and portfolio weights will change so it is important to also establish a regular rebalancing schedule for comprehensive portfolio assessment.
The Bottom Line
Style is a fundamental component of portfolio management. Comprehensively it is usually dictated by an investor’s risk tolerance. From there, investors also have a broad array of style options to choose from a more granular level.