Koenig: New Style Investing

January 08, 2014

Enhancement of defensive/dynamic indexes brings new perspective.

Style investing has been widely adopted by institutional and retail investors alike since Russell Investments introduced the first indexes based on size and valuation segmentation in the 1980s.

Since that time, style indexes have become standard benchmarks for measuring investment manager performance and important tools for asset allocation and portfolio construction. As of Dec. 31, 2013, assets in exchange-traded products and mutual funds benchmarked to style indexes totaled more than $1.4 trillion among more than 1,000 products, according to Morningstar.

But what exactly is "style"?

Investors have traditionally associated style investing with segmentation by size (large cap/small cap) and valuation (growth/value). However, in recent years, the concept of style has been enhanced with the introduction of indexes based on an additional risk dimension (defensive/dynamic).

While investors might once have considered value more defensive and growth more aggressive, research has shown that style is more nuanced and defensive/dynamic and growth/value represent different style dimensions.

Defensive and dynamic indexes take into account a company's historical stock price volatility as well as balance sheet and earnings "quality" characteristics such as leverage, earnings variability and return on assets.

Defensive-oriented companies have historically been more stable and less sensitive to business cycles, credit cycles and market volatility. Dynamic-oriented companies tend to be less stable and more economically sensitive, with typically higher-than-average stock price volatility.

This enhanced insight into style offers investors new ways to think about style to help them better understand markets and take greater control in constructing more precise portfolios based on their investment objectives and tolerance for risk.

Understanding Different Style Dimensions

Size

  • Large cap: Companies with higher market capitalizations
  • Small cap: Companies with lower market capitalizations

Valuation

  • Value: Companies with lower valuations and lower growth rates
  • Growth: Companies with higher valuations and higher growth rates

Stability

  • Defensive: Companies with less economic sensitivity and more stable earnings profiles
  • Dynamic: Companies with greater economic sensitivity and more variable earnings profiles

New Ways To Think About Style

Style leadership can vary significantly over time, so viewing the market through multiple style lenses can help investors better understand various market environments.

Just as large-cap and small-cap leadership can move in cycles, different market environments might favor value over growth, defensive over dynamic or some combination of styles. By viewing the market through all of these style lenses, investors have the opportunity for greater insight into market drivers and control over their portfolio's risk/return profile.

For example, defensive has historically led dynamic during periods of heightened market volatility and economic contraction. As shown in the chart below, during the market decline from Oct. 9, 2007 through March 9, 2009, the Russell 1000 Defensive Index significantly outperformed the Russell 1000 Dynamic Index.

This period also highlights that defensive is not simply value and dynamic is not simply growth. Over the same period, the Russell 1000 Growth Index outperformed the Russell 1000 Value Index, although the performance difference was smaller than for the defensive and dynamic indexes.

By contrast, dynamic-oriented companies have historically outpaced more defensive companies during cyclical recoveries. As the chart illustrates, during the market advance since March 9, 2009, the Russell 1000 Dynamic Index significantly outperformed the Russell 1000 Defensive Index.

During this period, the Russell 1000 Value Index led the Russell 1000 Growth Index, although the performance difference was again narrower than for defensive and dynamic.

Bear_Market

Bull_Market

Source: Russell Investments

 

 

 

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