Investors should mix ’n’ match styles to improve returns

Perhaps a little less obvious is the benefit of using managers with different and distinctive investment styles, such as ‘value’, ‘growth’, ‘momentum’, or so-called ‘quality’. The inclusion of such style managers as core drivers within an equity portfolio can potentially improve an investor’s long-term returns. But some investors find ongoing commitment to style managers challenging, often because their performance deviates strongly from that of the broader markets.

Value stocks are judged relatively cheap, perhaps reflecting a temporary downturn in profits, market sentiment, or some future potential that has not yet been fully recognised. By purchasing stocks trading below fair value, these investors attempt to establish a ‘margin of safety’, thus improving the risk/reward characteristics.

Growth stocks are companies experiencing above-average rates of profit growth. They typically trade at prices that are high relative to current profits. Meanwhile, quality stocks are well-established businesses with strong market positions, stable earnings growth, dependable dividends and conservative leverage. Their appeal is often strongest in times of uncertainty, when investors seek secure earnings and dividends.

Momentum stocks are those on a strongly rising trajectory.

The benefit of style-driven approaches is that, by employing well-defined criteria, the managers focus on stocks with particular characteristics and this brings additional disciplines to the decision-making process. They seek, over the long term, to outperform managers with a less-focused strategy.

Investment managers who achieve long-term outperformance nearly always experience protracted periods of underperformance along the way.. The critical issue is that those managers stick to their strategies, so that they get the full benefit of a change in sentiment when it comes.

Even the most successful investment firms, such as Warren Buffett’s Berkshire Hathaway, endure periods of underperformance. Since 1996 Berkshire has experienced three multi-year periods of underperformance versus the S&P 500 index, while overall outperforming the index by an impressive 74 per cent in relative terms.

Following a lengthy period of underperformance, the temptation to redeem may be high and investors often sell at precisely the wrong time. A combination of different style managers within an equity portfolio can help mitigate this pressure to sell. An example of the potential effect of style diversification can be demonstrated using a simple combination of two style managers: one following a value strategy; the other quality.

Throughout an extended period of lacklustre relative performance from the quality manager, the value manager was outperforming strongly. Similarly, during the period of underperformance from the value manager, the quality manager was performing well.

Driving this misalignment are the characteristics of the underlying holdings of the different investment styles. For example, quality stocks are typically considered safe havens. They often have characteristics that protect shareholder value in times of economic and market stress.

In contrast, a value manager attempts to identify stocks that are undervalued. In comparison to quality stocks, it is likely that value stocks are broadly perceived to have less certainty surrounding their future performance. For these reasons, value may sell-off more strongly in periods of stress. However, a judicious combination of the two can diminish the periods of underperformance and reduce volatility.

If style managers are to be considered, an adviser needs a deep understanding of the respective managers and must demonstrate an approach to monitoring that not only identifies changes in tactical positioning, but picks up subtle changes in strategy that may need to be highlighted and discussed.

In style investment, great rewards may theoretically be earned from timely switching between different styles, but the risk of getting the timing wrong is such that this is only warranted where there is strong conviction and, even then, the extent of the switch must be limited to avoid unbalancing the portfolio.

John Veale is the chief investment officer and Beni Pietropiccolo is a senior portfolio manager at Stonehage Investment Partners