A difference of styles
Style has thrived for more than 50 years in the US, serving the interests of managers, consultants, institutional investors and the informed private investor in a variety of complementary ways. Easily accessible style-related services and the appeal of style’s basic underlying philosophy (that only a limited number of investment considerations really matter) have contributed to its growing popularity. And, recently, style analytics and style-related practices have been particularly influential in the development of the retail and institutional funds market, where style labels have emerged as the accepted standard for fund classification.
And now style is rapidly gaining acceptance within Europe. Certainly much of the rising popularity can be associated with the developing market for investment through funds, but this is not the only reason for the surge in interest. For the investment manager, style banners plainly define investment products and enable marketing professionals to position services accurately towards clients and consultants. Style also offers the opportunity for business risk diversification (by offering investment products of different style orientations) and gives senior investment professionals a clear process for reviewing the portfolios of their colleagues. Among consultants, style techniques offer a mechanism to review the changing profiles of managers and add greater transparency to the manager selection process. And investment sponsors also benefit from the greater clarity style analytics brings and from the expanded choice it has encouraged.
Why then is European style so different from the US version?
Although the long-term popularity of style in the US has resulted in the segmentation of the market according to easily visible criteria, European markets are less clearly divided. Here it is considered important to review markets using factors and security criteria that reflect European market behaviour rather than simply the way investments or funds are most easily marketed. Differences across European economies and accounting standards and, in turn, differences from Europe to the US, argue against simplistic style characterisations of the European markets.
Without a set of standardised styles criteria it follows that returns-based style analysis will be difficult if not impossible to apply in the European markets. If managers cannot agree, for example, that book to price and size are the factors to use to position the style orientations of their investment products, what sense is there in using ‘stylised’ portfolios constructed from these factors, to interpret the performance of these products? Furthermore, since most European managers are thought to alter their style orientations more rapidly than their US counterparts, surely returns-based style analysis would also be suspect (since it requires some degree of style persistence to be able to identify anything at all).
Consequently, for European managers it was initially understandable that the only convincing style analysis services, for both market analysis and portfolio analysis, were based on a multiplicity of factors and bottom-up techniques for each of the major styles.
But much has changed over the past few years. Commercial interests aside, style characterisations of the UK and European markets have become more widely recognised and accepted within the academic and informed practitioner financial community. While only four to five years ago (before the formation of the Euro-zone), styles were difficult to detect within many European markets, the recent economic “harmonisation” has introduced noticeable style convergence. Since the formation of the Euro-zone (in fact, from even a year before the January 1999 start) styles have behaved in a broadly uniform manner across the Euro-zone and in the UK. Additionally, many awkward nuances of interpretation from factor to factor have also started to fade. As a number of researchers and index providers can confirm, value can now sensibly be characterised by simple averages of a small number of stock measures (such as book to price) and flow measures (such as dividend yield, earnings yield, cash flow yield or sales to price) and growth can also be simply represented as well.
So should we soon expect European style to become indistinguishable from US style practices?
Let’s hope not. There is still one fundamental difference between US theme-based managers and UK and European theme-based managers, and it is crucial that we recognise its importance. It has to do with confusing industrial or economic sectors with styles.
Even though the investment literature is very clear and definite, the index providers have written the US style rules and they have done it badly. The popular style indices for the US market do not adjust for systematic sector to sector differences in fundamental valuations. Consequently, all major US value indices display strong tilts towards financials, resources and utilities sectors and, correspondingly, growth indices are dramatically tilted towards information technology, non-cyclical consumer goods (pharmaceuticals) and general industries (electronics). The assumption is that if you want value, you must search almost exclusively in recognised value sectors and, even more questionably, if you want growth, you are expected to search only among the growth sectors. And this is 45 years after Peter Bernstein clearly warned “A firm cannot become a growth company ‘by association’.” (“Growth Companies vs Growth Stocks”, in the Harvard Business Review, 1956).
The US use of strongly sector-tilted benchmarks causes deep differences between US and non-US Style practices. Not only does it imply differences in investment strategies and in the provision of style-based investment services, it also causes some interesting divisions between US and European style-based services. The early difficulties encountered by returns-based portfolio style analysis services in the UK and across Europe were exacerbated by using style paradigm portfolios (the explanatory independent variables) that did not reflect the style strategies of the managers. UK and European managers were not tilting their sector investments in line with their style orientations, and the poorly constructed (ie, tilted) style paradigms consequently failed to identify manager strategies.
US managers may have no viable way to return to the more sensible management practices. But in the UK and across the Euro-zone it is imperative that we do not follow the lead of the simplistic index providers and abandon rational practices. Value managers should be able to seek out good value even within highly rated sectors, and growth managers must endeavour to identify promising companies, even (maybe especially), within sectors that are not currently in favour.
European style practices are developing rapidly and many investment managers are already promoting style-oriented investment products and services. Soon we will have an array of benchmarks to assess the performance and risk attached to these offerings. We must ensure that these benchmarks reflect the rational investment practices currently applied among European managers and that carelessly constructed indices do not gradually and subtly compromise the skills of our investment community.
Robert Schwob is director of Style Research in London