Investment Style

Investment Style Classification Process

The investment style classification process is a method used to categorize the stock universe into distinct groups. These groups are formed based on the similarity of characteristics among the stocks. For instance, stocks like Apple and Amazon may be categorized under the ‘Growth’ style due to their consistent increase in value. The returns of stocks within a style group are expected to be correlated with each other, while the returns of stocks in different style groups are expected to have less correlation.

Stocks can also be classified based on their membership in an industry, sector, or country group. For instance, stocks like JPMorgan Chase and Goldman Sachs belong to the financial sector, while stocks like Alibaba and Tencent can be classified under emerging markets.

• Importance of Style Classification: Essential for comparing active equity managers, enhancing decision-making by aligning managers’ strategies with suitable style indexes.
• Equity Style Attributes: Defined by pairs such as value vs. growth, and large cap vs. small cap, which provide insights into stock performance. A mix of these styles offers a broader understanding of return sources.
• Value of Identifying Styles: Critical for uncovering portfolio value sources and promoting diversification across strategies to optimize risk and reward.
• Evaluating Manager’s Style: Understanding a manager’s style is key to assessing performance and strategy adherence, thus enhancing the portfolio’s risk-return profile.
• Style Analysis Approaches: Holdings-based and returns-based methods are predominant, each with unique benefits. Selection depends on the context and goal of the analysis.

Two main approaches are often used in style analysis: a holdings-based approach and a returns-based approach.

Holdings-Based Approaches

Holdings-based approaches analyze equity investment styles by evaluating individual stocks’ attributes within portfolios, adopting a bottom-up perspective. Providers like Morningstar and Thomson Reuters Lipper use a binary style classification, assigning stocks to growth or value indices directly. Conversely, MSCI and FTSE Russell apply a multifactor approach, permitting stocks to display characteristics of both value and growth, according to specific inclusion factors. This results in the active exposure calculation of a portfolio, which aggregates the style attributes of all stocks, adjusted by their active positions. The approach varies among providers due to differences in criteria and data sources, leading to diverse style characterizations for the same portfolio.

Company Size Classifications

Companies are categorized into large-cap, mid-cap, and small-cap based on their market capitalization. However, the size thresholds for these categories are not universally agreed upon, and different data and research providers may use varying criteria for size classification.

Large-cap companies, such as Apple or Microsoft, are typically well-established with a strong market presence. They are known for their good levels of information disclosure and are extensively scrutinized by the investor community and the media. Although these attributes may not apply universally, large-cap companies are generally considered lower risk than smaller companies. However, they offer more limited future growth potential.

Mid-cap companies, like Zoom or Spotify, rank between large-cap and small-cap companies on many important parameters such as size, revenues, employee count, and client base. They are usually in a more advanced stage of development than small-cap companies but provide greater growth potential than large-cap companies.

Small-cap companies, such as Lemonade Inc or Beyond Meat, tend to be less mature with potentially greater room for future growth. However, they also have a higher risk of failure and receive a lower degree of analyst and public scrutiny.

Equity Style Analysis

Equity style analysis is a strategic approach used to assign a unique style score to each individual stock. This score is determined by a combination of several value and growth characteristics or factors of the stock. For example, in the value/growth style pair, each stock is assigned a value score based on these factors.

Application of Equity Style Analysis

Consider a real-world example where the price-to-book ratio is used as the sole factor to rank the stock. In this scenario, stocks like Berkshire Hathaway with smaller price-to-book ratios (P/Bs) make up the value index, while those like Amazon with higher P/Bs make up the growth index. The stocks are then weighted by their market capitalization to create both a value index and a growth index. It is crucial to note that each style index must represent 50% of the market capitalization of all stocks in the target universe.

Comprehensive Value Scoring Model

A more comprehensive value scoring model may use additional factors in addition to the price-to-book ratio. These factors can include price to earnings, price to sales, price to cash flow, return on equity, dividend yield, and others. These factors are combined through a predefined process, such as assigning a fixed weight to each selected factor, to generate the value score.

Value Score Calculation

The value score is typically a number between 0 and 1, which corresponds to 0% and 100% contribution to the value index. Depending on the methodologies used by the vendors, the value score may be a fraction. For example, a security with a value score of 0.6 will have 60% of its market capitalization allocated to the value index and the remaining 40% to the growth index.

Returns-Based Style Analysis

Returns-Based Style Analysis is a statistical method used to decipher the investment style of portfolio managers who do not disclose the full details of their portfolios. This approach compares the returns of the employed strategy to those of a set of style indexes. The objective is to find the style concentration of underlying holdings by identifying the style indexes that significantly contribute to fund returns. For instance, if a fund’s returns closely match those of a small-cap value index, it suggests the manager’s style leans towards small-cap value stocks.

Constrained Multivariate Regression

The analysis attributes fund returns to selected investment styles by running a constrained multivariate regression. The regression equation is as follows:

$$r_t = \alpha + \sum_{s=1}^{m} \beta_s R_{st} + \eta_t$$

where:

• \(r_t\) = the fund return within the period ending at time t
• \(R_{st}\) = the return of style index s in the same period
• \(\beta_s\) = the fund exposure to style s (with constraints \(\sum_{s=1}^{m} \beta_s = 1\) and \(\beta_s > 0\) for a long-only portfolio)
• \(\alpha\) = a constant often interpreted as the value added by the fund manager
• \(\eta_t\) = the residual return that cannot be explained by the styles used in the analysis

The key inputs to a returns-based style analysis are the historical returns for the portfolio and the returns for the style indexes. The critical part, however, is the selection of the styles used, as stock returns can be highly correlated within the same sector, across sectors, and even across global markets.

If available, the manager’s own description of his or her style is a good starting point for determining the investment styles that can be used. Commercial investment information providers, such as Thomson Reuters Lipper and Morningstar, perform the role of collecting and analyzing fund data and classifying the funds into style groups.

Manager Self-Identification

Manager Self-Identification, a key process in active equity management, involves managers declaring their investment style, often detailed in the fund’s prospectus, to outline the investment objective. Identifying investment styles, such as value/growth or large cap/small cap, utilizes returns-based or holdings-based analysis, aiding in verifying alignment with the manager’s declared style. However, certain styles, particularly in equity hedge funds and special sector funds, defy standard categorization, posing challenges for style identification. A combination of manager self-identification and analytical methods is effective for these non-standard styles. The fund’s prospectus plays a crucial role in this context, providing essential information for style assignment.

Strengths and Limitations of Style Analysis

Holdings-based Style Analysis

Holdings-based style analysis is similar to analyzing the ingredients of a recipe. It provides a detailed view of the portfolio’s composition, such as how Apple Inc.’s stock contributes to the technology style of a portfolio.

However, it requires comprehensive data on all portfolio constituents and their style attributes, which can be challenging to track historically. This method may also be less effective for portfolios with significant derivatives positions due to data limitations.

Returns-based Style Analysis

Returns-based style analysis, on the other hand, is like tasting the soup to determine its ingredients. It can be applied more broadly but may impose constraints that limit the detection of aggressive positions, such as a heavy investment in a small-cap biotech company.

Both methods rely on statistical and empirical research, which can produce inaccurate results due to data limitations or design flaws. Therefore, understanding these strengths and limitations is crucial for correct interpretation.

Practice Questions

Question 1: In equity investment style analysis, different commercial investment information providers use varying methodologies for holdings-based approaches. For instance, Morningstar and Thomson Reuters Lipper have a clear style classification process, while MSCI and FTSE Russell use a multifactor approach. The style classification process followed by Morningstar and Thomson Reuters Lipper for individual stocks can be described as:

1. A stock’s attribute for a specific style is 1 if it is included in that style index; otherwise, it is 0.
2. A stock can have characteristics of two styles, such as value and growth, at the same time.
3. A stock’s style is determined by a multifactor approach that assigns style inclusion factors to each stock.

Answer: Choice B is correct.

Morningstar and Thomson Reuters Lipper follow a style classification process where a stock can have characteristics of two styles, such as value and growth, at the same time. This approach is known as a holdings-based approach. In this approach, the style of a stock is determined by its characteristics rather than its inclusion in a particular index. The characteristics considered can include a variety of factors such as price-to-earnings ratio, dividend yield, and growth rate. This approach allows for a more nuanced understanding of a stock’s style, as it recognizes that a stock can exhibit characteristics of more than one style. This is particularly useful for investors who are looking to diversify their portfolio across different styles. It also allows for a more accurate comparison of different stocks and funds, as it takes into account the full range of a stock’s characteristics rather than just its inclusion in a particular index.

Choice A is incorrect. The statement that a stock’s attribute for a specific style is 1 if it is included in that style index; otherwise, it is 0, describes an index-based approach to style classification, not the holdings-based approach used by Morningstar and Thomson Reuters Lipper. In an index-based approach, a stock’s style is determined solely by its inclusion in a particular style index, which can be overly simplistic and fail to capture the full range of a stock’s characteristics.

Choice C is incorrect. The statement that a stock’s style is determined by a multifactor approach that assigns style inclusion factors to each stock describes the approach used by MSCI and FTSE Russell, not Morningstar and Thomson Reuters Lipper. In a multifactor approach, a stock’s style is determined by a combination of factors, each of which is assigned a weight. This approach can be more complex and difficult to interpret than the holdings-based approach.

Question 2: In holdings-based approaches to equity investment style analysis, the term “active exposure” is used. How is a portfolio’s active exposure to a certain style determined?

1. It is determined by the sum of the style attributes from all the individual stocks, weighted by their active positions.
2. It is determined by whether a stock is included in a specific style index or not.
3. It is determined by a multifactor approach that assigns style inclusion factors to each stock.

Answer: Choice A is correct.

Active exposure in the context of holdings-based approaches to equity investment style analysis is determined by the sum of the style attributes from all the individual stocks, weighted by their active positions. This means that the active exposure of a portfolio to a certain style is a function of both the style attributes of the individual stocks in the portfolio and the extent to which the portfolio manager has chosen to overweight or underweight those stocks relative to their weights in the benchmark. The active positions of the stocks are calculated as the difference between the portfolio weight and the benchmark weight of each stock. The style attributes of the stocks are typically determined based on fundamental characteristics such as size, value, and momentum. By summing up the product of the style attributes and the active positions of all the stocks in the portfolio, we can get a measure of the portfolio’s active exposure to a certain style.

Choice B is incorrect. Whether a stock is included in a specific style index or not does not determine a portfolio’s active exposure to a certain style. While the inclusion of a stock in a style index can provide some information about its style characteristics, it does not take into account the active positions of the stocks in the portfolio, which is a key component of active exposure.

Choice C is incorrect. A multifactor approach that assigns style inclusion factors to each stock is a method used to determine the style attributes of the stocks, not the active exposure of the portfolio to a certain style. While this approach can be part of the process of calculating active exposure, it does not provide a complete picture of active exposure, as it does not take into account the active positions of the stocks in the portfolio.

Glossary

• Active Exposure: The sum of the style attributes from all the individual stocks in a portfolio, weighted by their active positions.
• Market Capitalization: The total dollar market value of a company’s outstanding shares of stock.
• Equity Style Analysis: A method used to assign a style score to each individual stock based on its value and growth characteristics.
• Price-to-Book Ratio (P/B): A financial ratio used to compare a company’s current market price to its book value.
• Constrained Multivariate Regression: A statistical technique used to analyze the relationship between a dependent variable and multiple independent variables, subject to certain constraints.
• Manager Self-Identification: A process where a manager employs a specific strategy to manage a fund.
• Investment Style: A particular approach or strategy used in investing.
• Holdings-based Style Analysis: A method of style analysis that uses the actual portfolio holdings.
• Returns-based Style Analysis: A method of style analysis that uses the returns of the portfolio.

Portfolio Management Pathway Volume 1: Learning Module 2: Active Equity Investing: Strategies; LOS 2(k): Discuss equity investment style classifications