The Ebb & Flow Of Style Analysis

Knowing what you own in order to get a handle on expected risk and return is essential for successful investing in the long run. No one accidentally generates attractive risk-adjusted results through time (well, almost no one). There are many ingredients for minimizing the mystery of what’s driving results, but for equity portfolios the capitalization factor is probably the first factor to review. Small stocks tend to behave differently than large caps. A close second, and perhaps the dominant factor at times is the value/growth distinction. Numerous studies remind that companies with low valuations have different expected return and risk characteristics compared with their highly valued counterparts. What’s more, the relationship is far from constant. That’s old news, of course, as are the implications for number crunching, a.k.a. style analysis. The details, however, can get messy, as a recent essay by investment consultant Ron Surz of PPCA, Inc. reminds.

As a bit of background, Surz calculates a proprietary set of style indices—Surz Pure Style benchmarks—that he argues are superior to the usual suspects because they’re “mutually exclusive and exhaustive, and they include a style in between value and growth that we call ‘core'”. Long ago and far away I profiled Surz and his efforts at building style indices. In any case, he continues to argue that benchmarks without a core “are like Oreo cookies without the filling.” To be fair, his enlightened view of benchmarking styles is no longer an outlier. But few have been on this bandwagon longer, or have a deeper understanding of the issues.
Surz’s reasoning for measuring a core style is that in order to capture the value or growth factors cleanly it’s necessary to maximize each factor’s distinct profile. That means excluding the securities that only exhibit mild value or growth readings. This is a topical issue of late because, as Surz explains, of a widening divergence between so-called pure measures of value and growth compared with more popular style benchmarks:

A lot has happened in the past year, including movement toward agreement. Surz Style Pure classifications agreed with Russell and S&P prior to the 2008 meltdown, but have not agreed for the past 4 years as you can see in the following performance report. We disagree primarily because of financials.

Indeed, the unusual upheaval in banking and related industries means that certain financial stocks that were ranked as growth have migrated to core and perhaps value, and vice versa. Capitalization rankings have shifted too. The restless rotation rolls on, only more so in the wake of the Great Recession.
As such, the argument for keeping an eye on how your equity portfolio’s profile has evolved has never been more pressing. What you thought was growth may have taken on more of a value flavor, for instance. Or maybe the reverse is true. And then there’s the benchmark aspect. “In many economic environments it doesn’t matter much whose style definition you use, but that has not been the case in this economic crisis,” Surz advises.
Perhaps the main challenge with style analysis is that there’s much debate about what constitutes reliable benchmarks. No wonder that analysts are continually revisiting the subject, such as this recent study—“Returns Based Style Groups and Benchmarking”–that reviews “the suitability of two methods of returns based style analysis for classification of investment styles for a single asset class, US Diversified Equity Funds.”
The task of monitoring and maintaining a style strategy is harder if you hold individual securities. Alternatively, style- and capitalization-focused ETFs can ease the burden, assuming you pick intelligently designed products. The argument for building equity portfolios one security at a time is that you can add value over a relevant benchmark, intelligently crafted or otherwise. Maybe, but you’ll have to keep the guesswork about your style allocation to a minimum. Fortunately, there’s no shortage of resources on the web to help clear away some of the fog for how a given portfolio of stocks has evolved. As a starting point, you can give Surz’s Style Scan tool a run. Plug in the tickers and portfolio weights and compare how the results stack up against various benchmarks.
The key message is that rhetorically labeling portfolios “growth” or “value” is one thing, but quantitative analysis may beg to differ. None of this would matter if there wasn’t much difference in ex ante risk and return among styles. The truth, of course, is more complicated.