How investors can always be in style
The Financial Post takes a weekly look at tools that will help make your investment decisions. This week: Style rotation.
Investing in an equity style such as value or growth can be like a religion for investors, but not everyone is content with a portfolio of stocks that always share a common characteristic.
Instead of focusing on one particular style, many stock-market participants use a strategy known as style rotation, whereby assets are bought and sold to match the popular style(s) of the time.
Billionaire investment guru Kenneth Fisher, for one, has long believed that style selection is the single most important factor influencing portfolio returns.
“Folks think stock-picking is the most important investment skill. Wrong! In most years, financial failure or success is simply a matter of style,” he said back in 1999.
The potential success of style rotation has attracted numerous studies over the past two decades and, for the most part, they conclude the strategy is a positive one.
Researchers at Laval University in Quebec have further concluded that style-momentum strategies, which buy the best-performing style portfolios in any given month and short-sell the loser styles, can generate significant gains for investors.
“Over the period from 1960 to 2001, the average return of the winner is, on an annualized basis, more than 16% higher than that of the loser,” they said in a 2003 report. “This return difference is significantly larger than the difference between the average returns of any two style portfolios.”
The key to using style rotation successfully is largely attributed to determining when one or more styles will outperform others.
Studies show that value stocks outper form overall, but that growth stocks tend to do better during and immediately following recessions.
Meanwhile, the conventional wisdom regarding market capitalization is that small caps have historically done better than large caps during rising-rate environments.
Of course, there are exceptions to these rules that try to forecast the next great style winner and loser, but timing the rotation can be tricky. Mr. Fisher said it’s critical not to try to find the single best style, but rather try to find the best few styles, while avoiding the worst ones.
The best results come from always picking the best style, but this strategy is the most aggressive and risky, he said. But by avoiding the worst styles and owning the rest, he added, you still obtain very good results, which, on average, beat the market.
A recent report by Pyramis Global Advisors notes that “constructing portfolios based on a single favourable style can lead to missed opportunities to invest in strong-performing stocks.”
Joe Overdevest, a Pyramis portfolio manager, said in the report; “This analysis suggests that an approach to portfolio construction based on more-flexible and factoragnostic security- selection criteria offers the potential to generate relatively strong, and perhaps more consistent, risk-adjusted returns across varied market conditions.”