Europe's distinct lack of style
It is now some years since style analysis was introduced as a useful tool for investment managers and their clients, so how should we describe its current status in the world of equity investing? This report reflects a brief and informal survey conducted in recent weeks.
Style analysis goes back to academic work undetaken mainly in the US, which appeared to contradict the efficient market hypothesis – then almost universally accepted as gospel by the academic community. Although the academics focused on long-run returns on portfolios with style tilts, usually towards or away from Value stocks with relatively high dividend yields and low P/Es, or on the size of a company as defined by its market capitalisation, it also became clear that even short-run performance over a quarter or year could be significantly influenced by a manager’s style. Ken French and Eugene Fama were the acknowledged leaders in the field, although Bill Sharpe also wrote several seminal papers in the area.
Today, the Fama/French Journal of Finance papers from the late 1980s and early 1990s, are reputedly among the most referred-to papers in finance literature. French is also credited with the brilliant coup of putting all their time-series into the public domain, and giving everybody unrestricted access to their results. For a review article that summarises all the major findings on value and growth investing around the world, take a look at Chan and Lakonishok’s paper: ‘Value and Growth Investing: Review and Update’, published in January in the Financial Analysts Journal.
In the UK, Elroy Dimson, of the London Business School, has spearheaded the research. His recent paper with Stefan Nagel and Garrett Quigley reveals that the US findings can largely be replicated in the UK. The LBS value portfolio had outperformed the growth portfolio (though we should perhaps begin calling it the ‘glamour’ portfolio) by roughly 6% per year on average since 1955. The small cap effect was less pronounced but still positive.
The consultant community quickly caught on, with early adopters Frank Russell and Robert Schwob, in London, founding Style Research as a net-based service in 1996. Today, it is clear that no serious institutional investment manager can offer a service without first checking carefully on their firm’s investment style. To quote Chan and Lakonishok: “Value and growth are now widely recognised distinctive specialisations adopted by money managers.” Certainly the gatekeepers in the consulting fraternity will soon be asking questions about style, so that managers do now recognise the need to be prepared with answers, especially within the US and UK markets.
But in other aspects, progress has been slow. It is clear that a majority of managers are still very reluctant to be categorised by style. Even if it can be shown that they do have a style tilt, these managers probably feel that some doors are instantly closed to them if they espouse too narrow a mission statement, even though other doors may open more readily.
They know also that changing philosophy is seen by consultants as a good reason to put them on hold and cease recommending them. There is always plenty of competition that has had the same team/philosophy/
process since inception, with whom the consultant will feel more comfortable. So espousing a clear value or growth label can reduce a manager’s flexibility.
Instead, the ubiquitous but often meaningless GARP (growth at a reasonable price) philosophy is preferred. But who would not prefer dividend growth, all else being equal – though we can all agree it never is; and who would ever consciously pay the wrong price?
The analytical tools also continue to improve. Schwob and his colleagues noticed something strange in the aftermath of the dot.com collapse – the phenomenon of the disappearing growth manager. It turned out however on closer inspection that these managers now overweighted value stocks, and therefore obtained the more desirable label. However, they did so in a well-diversified manner, not straying too far within the value sub-portfolio into ‘deep value’.
Meanwhile, their more aggressive stock picking continued within the growth segment. So were they newly converted value managers? In the sense of money weight, yes they were. But their tracking error continued to owe more to their growth sub-portfolio, and on a risk-based measure they were still growth managers. Style Research now offers both measures.
A minority of managers do make it crystal clear where they stand and never change, but when the tide is flowing against them, the management of these firms sometimes face agonisingly difficult decisions. GMO for example, the Boston- and London-based value manager was haemorrhaging assets in the final years of the dot.com boom, and the decisions its board then faced have become the subject of more than one Harvard Business School case study.
Some very large managers, such as MLIM, M&G, Alliance and JPMF, have a special style issue because of their size and because of a history of takeovers or mergers where each party to the merger brought along a distinctive style. On the other hand, they also have the resources to be able to offer separate value and growth processes, each with their own research teams. Talking with a senior executive at one such firm, I asked what benchmarks were used for a style-tilted fund. The answer was surprising: normally, the broad market index, though not always. That meant, paradoxically, that the same fund may be reported to one client as underperforming and to the other as outperforming, depending on the client’s choice of benchmark.
Growth managers have had a torrid time in the last four years, but if the client consciously chose a growth manager (and it would be reckless to appoint a manager and not know the adopted style), surely it is not useful to compare performance with a broad index. Who owns that style decision? Surely the client owns it, not the manager. Inappropriate performance reporting can lead to poor and expensive manager-selection decisions by the client and his advisers, and unfair decisions for the incumbent manager when the tide is flowing hard against him.
Perhaps the clients prefer an inappropriate but familiar index that is in the newspaper every day, to a more appropriate but less familiar metric. (Both FTSE and MSCI have style indices for non-US markets, though they tend to get little coverage.) Perhaps clients simply take what the manager offers by way of performance reporting? So why do managers continue to report against unadjusted, broad indices, even when they are nowhere near the fence, let alone claiming to straddle it?
One reason might be that managers with a clear and consistent style obviously believe that in the long term, their type of securities will prevail, and they want to receive the credit for, and an active management fee for, that decision – and not just once, but every year. Thus it makes sense to compare with the broad index.
The history of the investment management industry shows that they should be worried. Vehicles designed to harvest the equity risk premium were turned into a commoditised low-cost product over 20 years ago. We call them index funds. Now the same is happening to the style decision and the value and growth premia.
Already the US has competing ETFs offering style index funds with total expense ratios below 20 basis points per annum, and turnover below 10% per annum. This gives institutional clients the chance to compare the active value manager with a passive vehicle that bears similar implementation costs, enabling the client and the consultant to focus on the ability of the manager to pick stocks within a clearly defined universe. The style decision, which belongs with the client, and the stock selection decision – for which the manager should be paid – are now more clearly segregated. It may also of course give the clients an opportunity to re-negotiate the management fee.
It seems that Europe is lagging behind the North American market in availability of low-cost passive vehicles available to institutional clients, as well as in terms of the degree of familiarity its institutional investors have with the available style benchmarks.
Style analysis is part of the equity landscape, but no-one would claim that on this side of the Atlantic at least it yet occupies a centre-stage position.
Mark Tapley is a former asset manager and currently a visiting fellow at the Cranfield School of Management