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Style matters

December 2016

By Simon Elimelakh, Head of Investment Risk, MLC

When investing for wealth creation there are a number of considerations to take into account. Like where an investor sits on the risk and return spectrum, their time to retirement, or the kind of investment manager they’d like to manage their money. But deciding between investment managers and strategies can be very complex and confusing.

At MLC, we utilise a number of selected managers to build portfolios for our clients. To determine which managers to invest with requires a significant amount of research and analysis, which our experienced teams have been doing for over 30 years. One of the key considerations we take into account is a manager’s ‘investment style’ which is a term commonly used to describe their investment process and the stocks they select. But how important is style, and to what extent does it affect a manager’s ability to deliver investment performance with an appropriate level of risk?

For many decades, investors have been referring to traditional equity managers along the categories of investment styles: manager ABC is a value manager, manager XYZ invests in growth stocks, etc. Popular styles you would be familiar with on top of value and growth could be size (small cap) and momentum, which have also been known for a long time. Others, like quality or low volatility have become more recognised styles recently.

So what defines investment style?

Each of these styles usually has specific ‘factors’ or ‘characteristics’ which are used to define them. Traditional equity managers with a style bias tend to consider these factors when choosing stocks for their portfolios.

For this article we have used definitions based on factors sourced from MSCI Barra – a world leading provider in indexing and investment risk-modelling. Chart 1 outlines the defining characteristics of each style.

Chart 1: Style definitions

Source: JANA, MSCI Barra

While each of these ‘styles’ has specific characteristics, it is important to remember that definitions of investment styles differ across the industry and are subjective. For example, some may define ‘value’ with a book-to-price ratio characteristic, whereas others may use dividend yield. This difference in definitions can lead to very different return outcomes from two managers who are both described as ‘value’. In fact, even styles based on the same financial ratio can differ substantially from one provider to another.

Style through the years

So how about the performance of different styles through time?

In comparing them, we can observe that all six styles have delivered positive returns in aggregate since 1995 and also over the last three years (see Chart 2).

Chart 2: Styles long-term returns to June 2016¹
(before deducting fees).

Past performance is not a reliable indicator of future performance. The value of an investment may rise or fall with the changes in the market. Source: JANA, MSCI Barra

All of these styles have (on average) outperformed global equity markets but, as usual, there is no free lunch. They have all experienced periods of underperformance. Chart 3 plots the same long-term returns against their respective deepest drawdowns (we define 'drawdown' here as 'the total loss over a continuous period of underperformance').

Chart 3: Style returns vs maximum drawdown¹

The data in this chart is created by JANA for style comparison purposes and cannot be relied upon as historical performance. Source: JANA, MSCI Barra

The chart shows that while some styles (eg value, growth, quality) are solid and stable, others like momentum have (on average) had higher returns but need to be used very cautiously as they have more chance of drawdowns.

Each to their own, but stronger together

Importantly, our analysis also shows that styles are not highly correlated ie potential risk and return varies considerably between them. This means it could be beneficial to combine several of them together to deliver a smoother sequence of returns. However, as with the uncertainty of financial markets, there are periods when even combining several styles cannot consistently deliver positive returns.

Take for instance Chart 4 which presents calendar quarter returns of the best performing style from the three traditional styles - value, growth and momentum.

Chart 4: the best of growth, value and momentum¹

The data in this chart is created by JANA for style comparison purposes and cannot be relied upon as historical performance. Source: JANA, MSCI Barra

Most of the time the returns of at least one of the three styles is positive but there are periods - like the GFC - when even the best one is negative. So even if you were able to pick the better one every quarter, which is nearly impossible, you would still have received a negative return. You can also see there was another really difficult period recently – from late 2015 to early 2016 - when the value, growth and momentum styles all underperformed. Coincidentally, that was the period when many equity managers - including managers used by us at MLC - underperformed their benchmarks.

The real influence of style, and the risk…

Having analysed the behaviour of these styles we now know what can be expected from them. So how important are styles for traditional managers and what is their style 'exposure'? We know it’s not 100% but is it possible to quantify?

Last year, in an article published in The Journal of Portfolio Management, Kahn and Lemmon from BlackRock analysed a large selection of global equity managers (138 managers). They found that (on average) 35% of the active risk (a measure of ‘activity’ relative to a benchmark) of the managers’ portfolios could be explained by their styles, with the other 65% being driven by the managers’ macro, industry, country and stock specific positions.²

Earlier this year, we completed a similar research project analysing the active global equity managers we employed in MLC’s global shares strategy and some of JANA’s institutional global equity portfolios. As a large asset owner we are in a rather unique position as we have daily access to the stock-level holdings of all the managers we use, allowing us to undertake a really deep analysis.

At the end, our findings very much supported Kahn and Lemmon’s results, as we found that the majority of our managers have a 30% to 40% exposure to styles. Interestingly, we also discovered that although style is a separate driver of returns to both country and industry allocations, a manager’s style can heavily influence these allocations. Chart 5 shows how much ‘growth’ bias our managers have and their corresponding investments in the internet and software industry. In fact, the overall correlation is 97%. This also provides some insight into potential risks which could be associated with relying on certain style portfolios in an unfavourable investment environment, lending further weight to the argument for diversification across styles and – as we will explain below – beyond style exposures.

Chart 5: Growth style exposures vs positions in internet software and services¹

Past performance is not a reliable indicator of future performance. The value of an investment may rise or fall with the changes in the market. Source: JANA, MSCI Barra

Smart beta isn't everything

Over the last few years, smart beta products have become a hot topic among investors. They are quantitative or ‘rules-based’ passive investments which are built to reflect a certain style, or combination of styles. You’re effectively buying, say, a value or growth portfolio which has been algorithm-generated, and is therefore likely to come at a lower cost for investors.

So the question could be asked, when allocating an exposure to global equities why would you use traditional equity managers rather than smart beta products? The answer is that the other (on average) 60% to 70% of managers’ risk and return is not explained by their styles. The managers we select aim to add value not only through their style positioning but also from other sources like industry and stock-specific risk and returns. This diversification of value-add sources should help them to continue delivering positive alpha even if their style of investing is currently out of favour. Chart 6 illustrates this by looking at the attribution of 12-month rolling alpha for one of MLC’s global equity managers, Intermede.

Chart 6: Intermede global equities: rolling 12-month return attribution1 (before fees)

Past performance is not a reliable indicator of future performance. The value of an investment may rise or fall with the changes in the market. Source: JANA, MSCI Barra

Historically, style has been a steady positive contributor to Intermede's performance - along with the other sources of risk and return - but lately, it has turned negative. Importantly, Intermede has managed to sustain their positive performance due to their good industry and stock specific selection, despite their style (and, potentially related, country/currency positioning) going through a negative period.

In conclusion, style does matter. It is naturally the driving force behind smart beta products but it also makes a significant contribution to the risk and performance of traditional equity managers. Importantly, we select managers who not only deliver positive performance due to their style exposures but combine it with other sources of alpha like specific stock selection. We then continuously monitor and analyse our managers' risk and return patterns against an ever-changing investment environment in our quest to deliver superior performance for our clients.


1. There is no guarantee that the positive returns associated with the styles will continue into the future. These positive returns in many instances can be supported or 'explained' by behavioural anomalies and/or being compensations (risk premia) for particular types of risk - and therefore they are historically probable and may continue but are not guaranteed. The explanations ('stories') associated with particular styles can be found in many smart beta promotional materials but are beyond the scope of this article.

2. 'Smart Beta: The owner's manual', Kahn R and Lemmon M, Journal of Portfolio Management, Winter 2015.

Important Information

This publication is issued by nabInvest Capital Partners Pty Limited (ABN 44 106 427 472, AFSL 308953) (“NCP”), a member of the National Australia Bank Limited (ABN 12 004 044 937, AFSL 230686) (“NAB”) group of companies (“NAB Group”). An investment in any product or service referred to in this publication does not represent a deposit or liability of, and is not guaranteed by NAB or any other member of the NAB Group.

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