Credit: Different dimensions of style

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Joseph Mariathasan reports on a new set of indices that add a defensive/dynamic dimension alongside market cap and value/growth

Active managers are judged on their ability to beat an appropriate benchmark. The selection of benchmarks is critical in evaluating whether performance is due to skill or luck. The benchmark needs to reflect the universe that the investment strategy can tap, and the minimum risk position is the benchmark itself, in the form of an index fund.

It is clear that the market can be split into segments that have common characteristics quite separate from a company's sector. Size is the most obvious factor. The creation of size indices in the US equity marketplace in 1984 by multi-manager investment firm Russell was catalysed by its observation that small cap managers were being judged by comparisons with the S&P500 alongside large cap managers. Given the cycles in relative valuations between small and large cap stocks, and the different marketplace that small cap investing represents, the idea that US small cap managers should be judged against a specific small cap benchmark such as the Russell 2000 index has become the norm.

Similarly, as Bill Jacques, CIO of Martingale Asset Management explains: "Post the 1973 crash, growth investing was the predominant style and investors realised they had to have diversification through employing managers with a value style as a counterpoint to growth." Russell's introduction of growth and value indices in 1987 solidified the idea of diversifying among managers by growth and value styles. Whilst other index providers have also produced style indices, the Russell indices are still the benchmark for the majority of US style products. Manager style has become a key factor in any US manager selection decisions and the balance between value and growth strategies and between small and large cap, is a critical issue for any US institutional investment fund. But style investing in Europe has never had anywhere near the prominence that it has achieved in America. One of the reasons appears to be that growth managers in the US sense are scarce in Europe. The European asset management industry does not have many good growth managers surviving after years in which value and small cap have dominated in performance. But moving to growth investing is not easy and value-oriented stock picking in growth segments does not work.

Whilst value strategies were initially seen as defensive and growth as aggressive, this has proved to be somewhat of a mirage: "In the last three years, value has morphed into something no longer defensive and growth into something no longer aggressive with value indices having a higher beta than growth" says Jacques. As a result, institutional investors have struggled when facing the issue of how best to reduce the risk of their equity portfolios without sacrificing too much return. But size and the value/growth dimensions are not the only way that investment approaches can be characterised and Russell has just launched a new set of indices which it believes add a third dimension to the traditional ones of size and value versus growth. The Russell stability indices are focused on the importance of stability variables in explaining market behaviour and investment manager returns. Jacques believes the stability indices offer the ability for institutional investors to tailor risk exposure much more precisely than using value and growth indices: "What they offer is the ability for institutional investors to de-risk their equity portfolios without sacrificing too much return."

Whilst they have been introduced for the US equity markets, global and European equity applications of the methodology will follow shortly and may be useful in providing more relevant indices for the European marketplace than value and growth.

According to the Russell stability index methodology, companies with greater exposure to certain risks are defined as dynamic, and companies with less than average exposure to certain risks are defined as defensive. Such companies not only have lower stock price volatility, but also have better quality balance sheets and earnings profiles. In contrast, dynamic companies have more risk, but historically their stock prices tend to increase faster than those of defensive companies during periods of rapidly rising stock prices. Dynamic companies also are more sensitive to economic cycles, credit cycles and market volatility and historically have tended to outperform stocks of defensive companies during strong market environments. For example, when the equity markets rebounded in early 2009, there was a ‘dash for trash' rally and whether a manager had a growth style or a value style seemed to matter less than whether that manager was positioned in defensive stocks or dynamic stocks. Dynamic stocks, and the managers who bought them, were winning.

Like Russell's value/growth indices, some companies can be partially in both indices, and again the sum of two indices such as the Russell 1000 defensive and the Russell 1000 dynamic gives the Russell 1000. As Russell makes clear, defensive companies are not ‘deep value' companies and dynamic are not ‘aggressive growth' with more companies being characterised as value-dynamic or growth-defensive than pure value-defensive or growth-dynamic in 2010. Instead, they believe stability represents another dimension to style, alongside the size dimension and the value/growth dimension.

The dynamics of stability indices
Over the past 20 years, defensive and dynamic stocks have outperformed each other in different economic and market cycles to varying degrees. Defensive stocks held up better in downturns (2000, 2001, 2002, and 2008), whereas dynamic stocks rose more quickly when stocks turned around quickly (1999, 2003, 2009).

Each style offers a different risk/reward profile in bull and bear markets. Defensive stocks offered a better risk/reward profile in a recent bear market, while dynamic stocks offered a higher reward (albeit at greater risk) in the recent bull market. Defensive strategies have outperformed the dynamic ones over the past 25 years so as Jacques argues, there is likely to be more interest from institutions in the defensive benchmarks, particularly as he sees that many funds will find themselves underweight when they do the analysis. However, dynamic strategies are likely to be popular with those who have a shorter term optimistic view of equity markets.

Stability index construction
The approach that Russell uses to calculate stability indices is based on combining a measure of the quality of a company's fundamental balance sheet and earnings characteristics together with a measure of the volatility of its share price.
What makes the stability indices a third dimension to style, and a complement rather than an alternative to value and growth, is that the latter are valuation-based measures of a company whilst defensive and dynamic represent non-valuation variables. The US value and growth indices produced by Russell used a two-variable model to determine the style classification of companies within the Russell 3000 index. Individual stocks within the Russell 1000 and Russell 2000 indices are allocated between the value and growth indices based on their rank relative to other companies in the index, as measured by a combination of valuation factors. The stability indices in contrast, give a measure of how sensitive a company is to changing business conditions and can therefore be regarded as a measure of the riskiness of a company. This measure of risk is more structured than using a traditional pure share price volatility as whilst half of the stability probability is comprised of stock total return volatility, the remaining half of the stability probability is based on three accounting-based quality variables that indicate a company's sensitivity to economic cycles, strength of a company's business model, and balance sheet leverage, which amplifies business results. Russell argues that for investment managers who examine changing economic cycles, credit cycles, and market volatility as potential risks to a company. Stability is more comprehensive than a pure low volatility approach.

Whether Russell's stability indices will achieve the level of prominence that their size indices and their value and growth indices have achieved in the US marketplace remains to be seen. Jacques argues that it will take at least five years for them to become accepted but he is very enthusiastic about them and believes they will eventually equal or even surpass in prominence the value and growth indices. But what is fascinating is that the stability indices may be more appropriate to the European market than value and growth. European institutional investors may find that the concept of defensive stocks adds another dimension to the ongoing debate of the role of equities within a liability driven investment (LDI) framework.

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