Style investing

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Style investing is an investment approach in which securities are grouped into categories, and portfolio allocation is based on selection among "styles" rather than among individual securities.

Contents

Style investors, then, make portfolio allocation decisions by placing their money in broad categorizations of assets, such as small-cap, value, low-volatility, or emerging markets. [1] Some investors dynamically allocate across different styles and move funds back and forth between these styles depending on their expected performance. [1]

Styles enable institutional investors to organize and simplify their portfolio allocation decisions, as well as to measure and evaluate the performance of professional managers relative to standardized style benchmarks [1] (see style drift). An implication of style investing is that it could impact financial markets, causing stocks to move together. [2]

Asset pricing

Style investing can be used in the study of asset prices and can serve as a useful framework for identifying anomalous price movements in stocks, and to then study the relation between risk and return in asset pricing models. See Returns-based style analysis.

As above, style investing generates co-movement between individual assets and their styles. [3] Momentum and reversal patterns exist both at style level and security level and style investing plays an important role in the predictability of returns. [3]

Barberis and Shleifer present a model where investors allocate funds based on the relative performance of investment styles which explains style momentum: "if an asset performed well last period, there is a good chance that the outperformance was due to the asset’s being a member of a “hot” style...If so, the style is likely to keep attracting inflows from switchers next period, making it likely that the asset itself also does well next period”. [4]

Style investing can also lead to mispricing: when a security is re-classified, such as when a stock is added to the S&P 500 index, its co-movement with the index increases while its co-movement with stocks outside of the index declines and possibly hurting performance. [5]

Classification

When classifying securities into styles, investors group together assets that appear to be similar, in the sense that they have a common characteristic. (Styles may then overlap asset classes.) A characteristic can be an obvious one such as the country in which the security is traded, or the industry in which the firm operates. [1] Other characteristics used as the basis for a style are based on size, risk, valuation, price return, or profitability. Value investing is well-known and emerged as a distinctive equity style following the work of Graham and Dodd (1934). [1]

Stocks can be split into categories such as small-cap, mid-cap, large-cap, value, defensive, cyclical, growth, international, regional, technology stocks, utility stocks, old economy or new economy, disruptive innovation, and so on. Classification of securities into categories is widespread in the financial field applying to other asset classes also. Bonds are split into high-yield bonds and investment grade bonds and short-duration and long-duration bonds. Traders classify assets as liquid securities such as private equity and public equity. They may also do the same with illiquid securities, such as private debt, illiquid hedge funds, direct real estate and venture capital. [1]

Financial industry

Financial firms Lipper and Morningstar developed and refined categorization systems and Style Box tools to aid with classification in the 1970s [6] and 1990s. [7] Also major index providers such as MSCI and FTSE offer a wide range of style-based indices. Also many asset managers offer style-based active strategies, sometimes also referred to as factor investing.

See also

Related Research Articles

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An exchange-traded fund (ETF) is a type of investment fund that is also an exchange-traded product, i.e., it is traded on stock exchanges. ETFs own financial assets such as stocks, bonds, currencies, debts, futures contracts, and/or commodities such as gold bars. Many ETFs provide some level of diversification compared to owning an individual stock.

The secondary market, also called the aftermarket and follow on public offering, is the financial market in which previously issued financial instruments such as stock, bonds, options, and futures are bought and sold. The initial sale of the security by the issuer to a purchaser, who pays proceeds to the issuer, is the primary market. All sales after the initial sale of the security are sales in the secondary market. Whereas the term primary market refers to the market for new issues of securities, and "[a] market is primary if the proceeds of sales go to the issuer of the securities sold," the secondary market in contrast is the market created by the later trading of such securities.

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A market anomaly in a financial market is predictability that seems to be inconsistent with theories of asset prices. Standard theories include the capital asset pricing model and the Fama-French Three Factor Model, but a lack of agreement among academics about the proper theory leads many to refer to anomalies without a reference to a benchmark theory. Indeed, many academics simply refer to anomalies as "return predictors", avoiding the problem of defining a benchmark theory.

<span class="mw-page-title-main">Asset allocation</span> Investment strategy

Asset allocation is the implementation of an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investor's risk tolerance, goals and investment time frame. The focus is on the characteristics of the overall portfolio. Such a strategy contrasts with an approach that focuses on individual assets.

A stock fund, or equity fund, is a fund that invests in stocks, also called equity securities. Stock funds can be contrasted with bond funds and money funds. Fund assets are typically mainly in stock, with some amount of cash, which is generally quite small, as opposed to bonds, notes, or other securities. This may be a mutual fund or exchange-traded fund. The objective of an equity fund is long-term growth through capital gains, although historically dividends have also been an important source of total return. Specific equity funds may focus on a certain sector of the market or may be geared toward a certain level of risk.

In finance, an asset class is a group of financial instruments that have similar financial characteristics and behave similarly in the marketplace. We can often break these instruments into those having to do with real assets and those having to do with financial assets. Often, assets within the same asset class are subject to the same laws and regulations; however, this is not always true. For instance, futures on an asset are often considered part of the same asset class as the underlying instrument but are subject to different regulations than the underlying instrument.

Core & Satellite Portfolio Management is an investment strategy that incorporates traditional fixed-income and equity-based securities, known as the "core" portion of the portfolio, with a percentage of selected individual securities in the fixed-income and equity-based side of the port folio known as the "satellite" portion.

Fundamentally based indexes or fundamental indexes, also called fundamentally weighted indexes, are indexes in which stocks are weighted according to factors related to their fundamentals such as earnings, dividends and assets, commonly used when performing corporate valuations. Indexes that use a composite of several fundamental factors attempt to average out sector biases that may arise from relying on a single fundamental factor. A key belief behind the fundamental index methodology is that underlying corporate accounting/valuation figures are more accurate estimators of a company's intrinsic value, rather than the listed market value of the company, i.e. that one should buy and sell companies in line with their accounting figures rather than according to their current market prices. In this sense fundamental indexing is linked to so-called fundamental analysis.

<span class="mw-page-title-main">Alternative investment</span> Investments other than stocks, bonds and cash

An alternative investment, also known as an alternative asset or alternative investment fund (AIF), is an investment in any asset class excluding capital stocks, bonds, and cash. The term is a relatively loose one and includes tangible assets such as precious metals, collectibles and some financial assets such as real estate, commodities, private equity, distressed securities, hedge funds, exchange funds, carbon credits, venture capital, film production, financial derivatives, cryptocurrencies, non-fungible tokens, and Tax Receivable Agreements. Investments in real estate, forestry and shipping are also often termed "alternative" despite the ancient use of such real assets to enhance and preserve wealth. Alternative investments are to be contrasted with traditional investments.

<span class="mw-page-title-main">Stock market index</span> Financial metric which investors use to determine market performance

In finance, a stock index, or stock market index, is an index that measures the performance of a stock market, or of a subset of a stock market. It helps investors compare current stock price levels with past prices to calculate market performance.

Dedicated portfolio theory, in finance, deals with the characteristics and features of a portfolio built to generate a predictable stream of future cash inflows. This is achieved by purchasing bonds and/or other fixed income securities that can and usually are held to maturity to generate this predictable stream from the coupon interest and/or the repayment of the face value of each bond when it matures. The goal is for the stream of cash inflows to exactly match the timing of a predictable stream of cash outflows due to future liabilities. For this reason it is sometimes called cash matching, or liability-driven investing. Determining the least expensive collection of bonds in the right quantities with the right maturities to match the cash flows is an analytical challenge that requires some degree of mathematical sophistication. College level textbooks typically cover the idea of “dedicated portfolios” or “dedicated bond portfolios” in their chapters devoted to the uses of fixed income securities.

Returns-based style analysis (RBSA) is a statistical technique used in finance to deconstruct the returns of investment strategies using a variety of explanatory variables. The model results in a strategy's exposures to asset classes or other factors, interpreted as a measure of a fund or portfolio manager's investment style. While the model is most frequently used to show an equity mutual fund’s style with reference to common style axes, recent applications have extended the model’s utility to model more complex strategies, such as those employed by hedge funds.

Low-volatility investing is an investment style that buys stocks or securities with low volatility and avoids those with high volatility. This investment style exploits the low-volatility anomaly. According to financial theory risk and return should be positively related, however in practice this is not true. Low-volatility investors aim to achieve market-like returns, but with lower risk. This investment style is also referred to as minimum volatility, minimum variance, managed volatility, smart beta, defensive and conservative investing.

Style drift occurs when a mutual fund's actual and declared investment style differs. A mutual fund’s declared investment style can be found in the fund prospectus which investors commonly rely upon to aid their investment decisions. For most investors, they assumed that mutual fund managers will invest according to the advertised guidelines, this is however, not the case for a fund with style drift. Style drift is commonplace in today’s mutual fund industry, making no distinction between developed and developing markets according to studies in the United States by Brown and Goetzmann (1997) and in China as reported in Sina Finance.

References

  1. 1 2 3 4 5 6 "Style Investing" (PDF). Harvard Institute of Economic Research.
  2. ↑ Barberis; Shleifer. "Style Investing" (PDF).
  3. 1 2 Wahal, Sunil; M. Deniz Yavuz. "Style Investing, Comovement and Return Predictability" (PDF).
  4. ↑ Barberis, Nicholas; Shleifer, Andrei (2003). "Style Investing". Journal of Financial Economics. 68 (2): 161–199. doi:10.1016/S0304-405X(03)00064-3. S2CID   261997541.
  5. ↑ Bennett, Benjamin; Stulz, René M.; Wang, Zexi (2020-07-20). "Does Joining the S&P 500 Index Hurt Firms?". Rochester, NY. doi:10.2139/ssrn.3656628. S2CID   226399267. SSRN   3656628.{{cite journal}}: Cite journal requires |journal= (help)
  6. ↑ Lim, Paul (1998-12-13). "Lipper's New Categories May Look Like Morningstar's, but They're Not". Los Angeles Times. Retrieved 2021-01-25.
  7. ↑ Polyak, Ilana (June 1, 2010). "Style Setter; By creating a taxonomy for mutual funds, Morningstar's Don Phillips has helped advisors build better portfolios". Financial Planning. 40 (6): 47 – via Factiva.
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