Equity Investment Style Classification

When it comes to finance, labels matter because they can define groups of stocks with similar characteristics. So how would you anticipate returns of these groups of stocks to be correlated?

These classifications are important because they allow active managers to compare their style to other managers. For example, a manager may take an active approach in their portfolio weights against the benchmark. However, the manager might also decide to weight the portfolio exactly the same as a mid-cap growth index, for example. What type of management do you think would best characterize this decision?

No. If stocks are in the same grouping, they should move together.

Incorrect. Groups of stocks with similar characteristics will have a correlation.

And these equity classification styles can also be used in a pairs comparison, like value and growth, large and small caps, high and low volatility, high and low dividend, and emerging or developed markets. From a modern portfolio theory perspective, efficient portfolio management uses a diversified portfolio of stocks and bonds, which can lower risk by including multiple asset classes. And it's a similar benefit to adding manager with different styles. What's the added benefit of adding managers with different styles?

Incorrect. This isn't specified by the manager's decision to weight the portfolio holdings in accordance to a specific index.

Not quite. This decision clearly suggests one of the two.

That's right! Lower volatility means lower risk, so adding active managers with different styles can help lower portfolio risk. That's why understanding the active manager's style helps with evaluation and this is where style analysis comes in. There are two main types of style analysis. A holdings-based approach calculates the active exposures (exposures greater or less in comparison to the index) to a certain style by adding up the style attributes from all the individual stocks, weighted by their active positions.

No. Specifically adding managers with different styles won't always result in higher returns.

Incorrect. Adding additional active managers wouldn't reduce management fees.

For example, one type of holdings-based approach is large cap, mid cap, and small cap. Although there's no absolute rule regarding size classifications, large-cap companies are usually well established with a strong market presence, good info disclosure, and extensive investor analysis. Small caps are generally regarded as the opposite of large caps, with more risk, higher growth potential, and less investor analysis. Mid caps, to nobody's surprise, fall in between large and small, with more advanced development than small caps, but higher growth potential than large caps.

Another type of "characteristics based" portfolio style is growth, value, or core. This is measured by using an individual stock style scoring system. For some systems, it can be a sophisticated system with multiple factors like P/E, P/B, P/S, P/CF, ROE, Dividend yield, and more. In other cases, the basic system will use P/B to define stocks into growth or value. So what kind of P/B value would you expect a value stock to have?

When it comes to returns-based style analysis, this approach is used as a substitute to holdings-based analysis when managers don't disclose their portfolio holdings. So instead of comparing the manager's internal holdings, the returns are compared to analyze the manager's abilities. What do you think the manager's style returns are compared to?

Incorrect. A high P/B ratio indicates that the stock trades at a multiple of the stock's book value.

Incorrect. An average P/B ratio indicates that there's really no deviation between growth and value.

Incorrect. Other managers could have various weights within their portfolio that blur the lines between value and growth.

Correct. Style benchmark indexes are used to compare manager styles for return-based style analysis. So the objective of a returns-based style analysis is to find the style concentration of underlying holdings by identifying their style indexes that provide significant contributions to fund returns with the help of statistical tools. This approach involves multivariate regression: $$r_t = a + \sum^m_{s=1} \beta^{s}R^{s}_{t} + \epsilon_t$$ where $$r_t$$ is the fund return within the period ending at time $$t$$, $$R^{s}_{t}$$ is the return of the style index $$s$$ in the same period, $$\beta^s$$ is the fund exposure to style $$s$$, $$a$$ is a constant often interpreted as the value added by the fund manager, and $$\epsilon_t$$ is the residual return that cannot be explained by the styles used in analysis. Essentially, the key inputs are the historical returns for the portfolio and the returns for the style indexes. But you'll need to be careful to ensure that the styles are clearly defined.

That's not it. Total benchmark indexes won't compare a manager's specific style weightings via returns.

Another way to identify a returns-based style analysis is to simply rely upon the manager's self-identification of their strategy. This usually involves reading the prospectus to identify the fund's objective, especially if the strategy is more complex or involves unique investments. What type of fund might be best for self-identification?

No. A large-cap value fund will have specific holdings that can be identified.

That's not it. Small-cap growth funds can be analyzed with holdings-based approaches.

Yes! A long–short equity fund is not a standard fund and it is best analyzed using self-identification. Plus, since this strategy is typically a hedge fund, it's not going to reveal its holdings. That's why the prospectus is a key tool used in identifying the holdings. Not surprisingly, holdings are a key aspect of any style analysis, as the portfolio's holdings reveal the true exposure and provide input for style allocation decisions. Yet this requires the availability of all holding data as well as style attributes for each holding. This also brings in risk associated with the data, as data sources can be limited and not applicable in the case of securities like derivatives. For these reasons, research shows that holdings-based analysis produces more accurate results, but returns-based approaches can be more widely applied. Hence, it's best to do both and know the models in order to interpret results correctly.

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Correct! Stocks within a similar grouping should be expected to have correlated returns, and that's why you would expect to have correlated returns amongst similar active management styles like value, growth, blend, size, price momentum, volatility, income, and earnings quality. These styles can also include an industry, sector, or country group.

Right! If the active manager's weightings are the same as that of an index, then the portfolio is passively managed, even though some of the weightings may give the impression of active management. That's why it's important to classify equity styles to help managers compare.

That's right! Value stocks have lower P/B ratios because they trade close to their book values. This means that a stock that's weighted by a value score that has a low P/B ratio will score higher on the value scoring chart. The value score runs for 0–100%, with 100% indicating a solely value stock. Any percentage lower than 100% will have some growth characteristics.

Positively

Negatively

No correlation

Passive

Active

Could be either

Higher returns

Lower volatility

Lower management fees

Low

High

Average

Other managers

Style benchmark indexes

Total market benchmark indexes

Large-cap value fund

Small-cap growth fund

Long–short equity fund

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