Investment style

Investment style refers to different style characteristics of equities, bonds or financial derivatives within a given portfolio or fund, or in an asset class or fund within a larger portfolio. The investment style of an index fund or an actively managed mutual fund helps set expectations for long-term performance potential and aids in advertising the fund to investors looking for a specific type of market exposure.

Investment styles can be broadly classified as passive versus active. They can also be classified according to the Morningstar Style Box&trade; system (below).

This article attempts to summarize investment styles to give you some background on how they may be used.

Style vs. strategy
In investing, the terms style and strategy are not generally well defined and sometimes (often?) used interchangeably (e.g., by the Globe and Mail ).

Styles
Three categories of investing style are commonly used in the mutual fund industry (e.g. by Morningstar) - active vs. passive management, growth vs. value investing, and market capitalization.

Passive investing
Passive investing (also called passive management) is a strategy in which an investor (or a fund manager) invests in accordance with a pre-determined strategy that doesn't entail any forecasting (e.g., any use of market timing or stock picking would not qualify as passive management). The idea is to minimize investing fees and to avoid the adverse consequences of failing to correctly anticipate the future. The most popular and time-tested passive strategy is called indexing, and most index investors use ETF and mutual funds that target cap-weighted indexes (more on this below), in order to own the entire market and minimize management fees and portfolio turnover.

Active management
Active management attempts to outperform the market, lower the risk of a portfolio, or increase its yield, using various techniques.

These strategies can be implemented by buying mutual funds, specialized exchange-traded funds (ETFs) (e.g., dividend ETFs or low-beta ETFs), or through stock picking (building a portfolio of individual stocks).

Canadian mutual funds with active management have a hard time beating their benchmarks over five years.

Smart beta products employ a mild form of active management that relies on following per-established rules, rather than on human judgment. Relative to a cap-weighted indexing strategy where is goal is to own "the market", smart beta strategies target specific factors such as company size, value, dividends, quality, profitability, etc.

Growth vs. value
Value investing and growth investing are two widely followed investment strategies that have different styles. Each has their own advocates and supporters. There are also a broad range of definitions for each.

In 1994, academics Josef Lakonishok, Andrei Shleifer, and Robert Vishny published “Contrarian Investment, Extrapolation, and Risk.” Using data from 1968 through 1994, they grouped U.S. stocks into value and growth segments based on price-to-book, price-to-cash flow, and price-to-earnings ratios, as well as sales growth. The researchers concluded that, for a broad range of definitions of “value” and “growth,” value stocks consistently outperformed growth stocks by wide margins. In addition, this outperformance remained robust when the stock samples under review were limited to the larger-capitalization stocks typically favored by large investors.

Since that date, a great deal of academic empirical research has been published on value and growth investing.

Market capitalization
Market capitalization (market cap) is the total market value of the shares outstanding of a publicly traded company; it is equal to the share price times the number of shares outstanding. As outstanding stock is bought and sold in public markets, capitalization could be used as a proxy for the public opinion of a company's net worth and is a determining factor in some forms of stock valuation.

Traditionally, companies were divided into large-cap, mid-cap, and small-cap. The terms mega-cap and micro-cap have also since come into common use, and nano-cap is sometimes heard. Different numbers are used by different indexes; there is no official definition of, or full consensus agreement about, the exact cutoff values. The cutoffs may be defined as percentiles rather than in nominal dollars.

The market cap thresholds also vary between countries. The Canadian stock market, as denoted by the Toronto Stock Exchange (TSX), is approximately 1/10 the size of the US stock market, as can be seen in the following table (data as of close-of-market December 31, 2015):

Market cap thresholds and ranges
An alternative to rigid cutoffs is to have partly overlaping ranges of market caps, as shown in the following figure based on S&P indexes as of December 31, 2015 (all numbers in million dollars, in USD and CAD, respectively):



Smid cap?
Reckamp compares the S&P indices shown above with the equivalents from Russell, for US Equities. He concludes that combining small and mid-cap stocks into a 'smid' category "can provide all the benefits of small and mid cap investing, as well as a few not provided by either investment". In Canada, the Canadian Investment Funds Standard Committee also has a combined category known as 'Canadian Small/Mid Cap Equity'.

Tilting
Historically, value stocks and small stocks have provided higher returns than growth stocks or large stocks, respectively. Some investors choose to add additional value and small stocks to their portfolios; this is known as tilting, and developed further in Multifactor investing - a comprehensive tutorial. Other factors such as low volatility or profitability are becoming popular, and factor investing (sometimes along with some forms of dividend investing) has recently been re-branded as "smart beta". Note that the timing and magnitude of the premiums associated with factors will always be uncertain, i.e. past performance does not predict future performance.

Style boxes
The Fama and French three-factor model explains the performance of equity portfolios using three factors: beta (the measure of market exposure of a portfolio), company size (small versus large market cap) and value versus growth. The latter two factors are used in “style boxes”, which are 3 x 3 grids used to categorize porfolios or funds. Different investment styles have various levels of risk which leads to differences in returns. This visualization allows investors to perform informed comparisons using an easy-to-understand standardized format. For equities (stocks and stock funds), securities are classified by market capitalization on the vertical axis, and value and growth factors on the horizontal axis.

A certain fund or collection of stocks can then be placed in the style box and compared with others.

Morningstar Style Box
The Morningstar Style Box&trade; is a nine-square grid that provides a graphical representation of the "investment style" of stocks and mutual funds. For stocks and stock funds, it classifies securities according to market capitalization (the vertical axis) and growth and value factors (the horizontal axis). Fixed income funds are classified according to credit quality (the vertical axis) and sensitivity to changes in interest rates (the horizontal axis).

The vertical axis of the Style Box defines three size categories, or capitalization bands-small, mid-size, and large. The horizontal axis defines three style categories. Two of these categories, "value" and "growth," are common to both stocks and funds. However, for stocks, the central column of the style box represents the core style (those stocks for which neither value or growth characteristics dominate); for funds, it represents the blend style (a mixture of growth and value stocks or mostly core stocks).