Investing in diversified portfolios involves consideration of the characteristics of valuation-based and capitalization-based styles. In this article, we’ll look at some basic elements of style investing and examine the phenomenon of apparent systematic anomalies, such as the value effect and the small-cap effect, that are well documented in portfolio management experience. Finally we provide some basic how-to advice on the construction and maintenance of a style-based portfolio.

What Is Style Investing?

Style refers to asset groups within a broad category (such as equities or fixed income) that display similar fundamental characteristics. The two most common equity style measures are valuation and capitalization. Valuation style divides stocks into value. growth and core. Value is characterized by low valuation multiples like price to book (P/B) and price to earnings (P/E). Growth is believed to have higher-than-average sales and earnings growth prospects. Core is a blend in between value and growth.

For example, the Russell Investments operates a series of style indexes with two valuation measures: the P/B ratio, the Institutional Brokers Estimate System (I/B/E/S) medium-term forecasted growth estimate (two years), which is a compilation of earnings estimates provided by investment analysts from more than 850 global investment organizations, and sales per share historical growth. These variables are combined into a composite value score, based on which 70% of the stocks are classified as all-defensive or all-dynamic with the remaining 30% in either the growth or value index.

The other traditional equity style measure is market capitalization. Russell, by way of example, ranks 4,000 publicly traded U.S. companies as follows: The Russell 1000 Index contains the top 1,000 stocks by market cap, the Midcap Index is made up of the 800 smallest names in the Russell 1000, and the Russell 2000 Small Cap Index features stocks with market caps that rank them from 1,001 to 3,000. At the bookends of the capitalization spectrum are the Russell Top 200 Index of mega-cap stocks and the Microcap Index (3,001 to 4,000).

Does Style Matter?

Style and Asset Allocation

Style is integral to many asset allocation strategies and, as such, is a key element of modern portfolio management. Studies conducted over the years show evidence that the asset allocation decision is a significantly more important attribute of portfolio performance over time than, say, individual investment selection or market timing. For example, the widely-known Brinson Hood Beebower study entitled Determinants of Portfolio Performance (Financial Analysts’ Journal. 1986) showed that 93.6% of performance was due to allocation attribution.

Asset allocation involves a risk decision — the mix of equities, debt and alternative assets based on an investor’s particular risk tolerance — and a style decision, or a specific mix of value, growth, large and small cap and other style types

The Curious Case of Style Effects

Over the years, investment practitioners have observed that certain styles appear to exhibit persistent outperformance over long time periods. Perhaps the most well-known of these so-called style effects relate to value stocks and small-cap stocks. For example, James O’Shaughnessy’s book, What Works On Wall Street, which was originally published in 1996, documents portfolio performance back to 1963 and affirms both the value effect and the small cap effect. O’Shaughnessy published a follow-up article in 2007 where he noted, with some apparent bemusement, that despite the amount of literature written and published about these effects, they appeared to be as intact as ever; in other words, the outperformance had not been arbitraged away as we might expect.

The chart below shows total annualized returns for four styles over a 34-year period from 1979 to 2013 as measured by the Russell indexes. The Russell 3000 Value and Growth are all-cap valuation style indexes while the Russell 1000 and 2000 are all-valuation capitalization style indexes.

The results appear to show evidence of a value effect as well as a more modest small cap effect. Over the 34-year period, value stocks outperformed their growth counterparts. Small cap stock indexes, like the Russell 2000, returned slightly below than the large cap Russell 1000 and the S&P 500.

The really interesting thing about this chart, though, is that value’s outperformance was achieved with significantly lower risk (standard deviation ). This runs counter to the commonly accepted notion that high return equals high risk. The somewhat bizarre evidence shown here and in other value effect studies seems to be the capital market equivalent of a free lunch.

How can a supposedly efficient capital market persistently reward a particular style this way? One answer comes from practitioners of behavioral finance. They argue that human emotions strongly influence investment decisions and lead to systematic, seemingly illogical outcomes. The value effect, according to the behaviorists, comes about because investors are emotionally attracted to the allure of growth stocks as a result of the greater amount of attention and media coverage growth stocks receive compared to value stocks. Ultimately, this contributes to the decision to invest in these rather than in cheaper, more boring value names. In other words, human emotion gets in the way of rational value maximizing and keeps these anomalous effects from self-correcting as we might assume they would.