In this article
- Investment styles impact fund return potential
- Active vs. passive investing styles
- Growth vs. value approaches
- Know a fund manager's style before investing
What's Your Investment Style?
The growth in the number of mutual funds is due, in part, to the variety of investment styles employed by money managers. Studies have shown that investment style can play an important role in fund returns; as a result, there is considerable debate within the investment community about the effectiveness of the various styles. The following is an overview of the dominant styles employed by today's money managers.
Active vs. Passive
Active investors believe in their ability to outperform the overall market by picking stocks they believe may perform well. Passive investors, on the other hand, feel that simply investing in a market index fund may produce potentially higher long-term results. In the past 10 years, actively-managed funds invested in U.S. large-cap stocks outperformed their passive counterparts only 14% of the time, according to Morningstar.* Passive investors believe this is due to market efficiency, the theory that holds that all information available about a company is reflected in that company's current stock price, and it's impossible to forecast and profit on future stock prices. Rather than trying to second-guess the market, passive investors can buy the entire market via index funds.
Active investors counter that managed funds don't always underperform the general market. Many funds have earned significantly higher returns. Active investors believe that the market may not always be efficient and that through research, active fund managers may be able to uncover information not already reflected in a security's price and potentially profit by it. For example, some active investors feel that the small-cap market is less efficient than the large-cap market since smaller companies are not followed as closely as larger blue-chip firms. A less efficient market could potentially favor active stock selection, they reason.
*Source: Morningstar, Active-Passive Barometer 2016, March 2017.
Growth vs. Value
Active investors can be divided into growth and value seekers. Proponents of growth seek companies they expect (on average) to increase earnings by 15% to 25%. Of course, there is no assurance that this objective will be obtained. Stocks in these companies tend to have high price to earnings ratios (P/E) since investors pay a premium for higher returns. They usually pay little or no dividends. The result is that growth stocks tend to be more volatile, and therefore more risky.
Value investors look for bargains -- cheap stocks that are often out of favor, such as cyclical stocks that are at the low end of their business cycle. A value investor is primarily attracted by asset-oriented stocks with low prices compared with underlying book, replacement, or liquidation values. Value stocks also tend to have lower P/E ratios and potentially higher dividend yields. These potentially higher yields tend to cushion value stocks in down markets, while certain cyclical stocks will lead the market following a recession.
Other investors choose not to lock themselves into any one investment style. Returns on growth stocks and value stocks tend not to be highly correlated. This means that an increase or decrease in one type may have little effect on the other. By diversifying between growth and value, investors can help manage risk and may still have high long-term return potential.
Small Cap vs. Large Cap
Some investors use the size of a company as the basis for investing. Studies of stock returns going back to 1925 have suggested that "smaller is better." On average, small-cap stocks have outperformed large-cap stocks over long holding periods. But since these returns tend to run in cycles, there have been long periods when large-cap stocks have outperformed smaller stocks.
Small-cap stocks also have higher price volatility, which translates into higher risk. Some investors choose the middle ground and invest in mid-cap stocks with market capitalizations between $500 million and $8 billion -- seeking a trade-off between volatility and return. In so doing, they give up the potential return of small-cap stocks.
Sources: Standard & Poor's; Center for Research in Securities Pricing (CRSP). Large-cap stocks are represented by the S&P 500 Index, an unmanaged index that is generally considered representative of the large-cap, U.S. stock market. Small-cap stocks are represented by a composite of the CRSP 6th-10th decile portfolios and the S&P SmallCap 600 Index, unmanaged indexes that are generally considered representative of the small-cap, U.S. stock market.
Bottom-Up vs. Top-Down
A top-down investor looks first at economic factors and then selects industries accordingly. For example, during periods of low inflation, consumer spending increases, which might be a good time to buy automobile stocks or retail stocks. The top-down investor would then search for the best values in these industries. A bottom-up investor is more concerned with individual companies' fundamentals. They reason that even if its industry is doing poorly, a hot company will still outperform the market. Both of these styles emphasize fundamentals, but place different emphasis on the economic environment.
Technical vs. Fundamental Analysis
Another difference is that some equity investors look at the fundamentals of individual stocks, while others invest based on technical analysis. Fundamentalists, who represent the majority, spend time poring over annual reports and visiting companies attempting to uncover investment opportunities and seek greater return potential over the long run. Technical analysts pore over charts of stock prices and economic data in an attempt to divine patterns that could be indicative of future trends, and are more concerned with short-term market timing than individual stock picking.
Although technical analysts fell out of favor as studies questioned their forecasting powers, increased access to information and the growing power of computers have led to a resurgent interest.
Asset Allocation: Another element of investing "Style"
Another popular investment strategy is asset allocation. Market timing purists move in or out of specific asset classes (stocks, bonds, and money markets1), based on the forecasts of their technical models. A more conservative approach, dynamic asset allocation, uses risk/return trade-offs to determine which class of assets to favor. However, asset allocation does not guarantee a profit or protect against a loss.
If bonds are seen to be "cheaper" than stocks, then the allocation will favor bonds. Asset allocators continually adjust their portfolios based on market and economic conditions.
1An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the fund.
When in doubt, consider diversification
In order to manage volatility, many experts encourage diversifying based on investment style. Mutual fund investors need to ask questions, carefully read the fund prospectus, and consult fund rating services to make sure they are buying a style that is right for them. Figuring out which -- and how many -- of these styles are right for you can be challenging. Your financial professional can help you negotiate this maze and help you make choices that complement your overall strategy.
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