Style investing generally produces a lifecycle of investment styles. So, investors should not look at the frequency, average gain or size in isolation but rather consider frequency and size of gains together
An essential element of human thought is classification—the grouping of objects into categories based on some similarity among them. Accordingly, we group countries based on their political systems, occupations based on the nature of jobs, food into groups such as carbohydrates and proteins as per their composition.
Classification is also pervasive in financial markets, leading to style investing. Assets of the same style co-move too much whereas assets of different styles co-move too less and re-classifying an asset into a new style raises its correlation with that style. Let us discuss style investing in detail.
What is style investing?
While making portfolio allocation decisions, often investors first categorise the assets into broad classes such as large-cap stocks, value stocks, government bonds, etc., and then decide how to allocate their funds across these various asset classes. The asset classes that investors use in this process are also known as ‘styles,’ and the process itself, namely allocating funds among styles rather than among individual securities, is known as style investing.
Assets in a style or class share common characteristics such as their nature of claim (equity or debt), maturity of claim (treasury bills or long term debt), timing of delivery (cash market or forward market), as per the market capitalisation (example small-cap or otherwise). In some cases, the cash flows of assets in the same style are highly correlated while some other assets like closed-end funds are largely uncorrelated.
Style is not static
There is a fundamental connection between economic cycles and style cycles. Value stocks tend to do well when the economy is strong or during cyclical recovery whereas growth stocks tend to do well when the economy is growing more slowly than usual. So, economic and style variables are intrinsically correlated. Some styles are relatively permanent over the years; for instance, government bonds. Styles disappear after long periods of poor performance, as was the case with railroad stocks and bonds issued during World War II.
The combination of long-term economic cycling effects and short-term behavioural trends can be captured by style rotation strategies. As style portfolios are constructed using constant rules, their history can be back tested over many years. Going back to the early 90s of changing regimes when the economy was opened up, style portfolios display positive bias such as value, growth, momentum which is known as style opportunity. Style returns can be exceptionally strong in defined regimes and particularly in falling markets, as persistence is stronger on the downside because the fear sentiment is more quickly assimilated by market participants than greed.
Better risk management
Style investing is a neutral methodology with no concepts like beta, market, exposure, etc. In line with most quantitative strategies, risk limits and targets are computed and calibrated and there is no discretionary input. This is key to success as, in recent times, markets have experienced some significant individual stock moves on a day.
To conclude, style investing generally produces a life cycle of investment styles. So, investors should not look at the frequency or the average gain or size in isolation but they should consider frequency and size of gains together.
The writer is a professor of finance & accounting, IIM Tiruchirappalli