Almost every pension fund portfolio has both growth and value investments in it. Many years ago the terms growth and value were first used to describe the type of stocks an active manager tended to use as a basis for their portfolio. The names characterised the managers’ ‘style of investing’. If a manager bought stocks from which he expected capital appreciation regardless of the current price, he was considered a growth manager. If a manager bought stocks that were fundamentally sound but for some reason were trading at a price-to-earnings multiple below that of the general market, he was considered a value manager.
The managers soon caught on. Of course they wanted to appeal to the greatest possible audience, so no matter which stocks they favoured they declared they always bought stocks that were undervalued considering their great expectations. To keep these clever managers straight, benchmarks were developed that attempted to divide the market into three style sections, growth, value and neutral, and indeed these sections had less than perfect correlation. In the Dow Jones STOXX Total Market Index for example almost 28% of the 982 companies are considered neutral. So including neutral as a third style reduces the dilution of value and growth sections significantly. The next logical step was for many investors to wonder, “Why do I bother with an active manager? Why don’t I simply use an investment based on these benchmarks and stop worrying whether my manager is staying true to his style?” Thus, indexed style investing was born.
Of course, it was another case of how benchmarks designed for one purpose came to be used for another, spawning trouble in the process. That trouble is, trying to define style in a manner that fits every perspective. For some investors ‘growth’ and ‘value’ refer to stock characteristics. For others these terms refer to a market condition. The best definition that I can offer through experience is that growth and value represent the expectation for a group of securities based on the current positive or negative market sentiment.
My favourite analogy is that of a rocket and a parachute. Growth stocks are the rockets that use positive market expectation as fuel. These are the stocks that would be first to reap the benefit of rising profits in a rising market. Famed portfolio manager Peter Lynch says: “Price follows earnings.” It may be more accurate that in a speculative environment price follows the expectation of rising earnings. On the other hand, value stocks tend to be the parachutes that investors start looking for when the rocket sputters. These are the stocks that are expected to ease the fall in a declining market. Many factors influence this perceived behaviour, such as dividend payments, a stock price that is low in relation to the company’s per-share ‘book value’, sustainable sales from an established brand or business franchise, and others.
One factor that influences growth or value perception is a stock’s industry group. Many times a bull market is led by an industry group or market sector, which can influence whether a stock is seen as a growth stock or a value stock. This group context can override individual company fundamentals, leading investors to buy stocks with weaker fundamentals than other stocks in, less favoured industry groups. By contrast, in a down market such as the one following the tech bubble that peaked in the US in 2000, the babies were thrown out with the bath water. The end result is that under a certain market condition a stock whose low price-to-book ratio would ordinarily cause it to be considered a value stock may be acting like a growth stock; or a growth stock with robust sales growth may be plugging along like a value stock. Whether this phenomenon is a distortion or clarification of the meaning of growth and value depends on your perspective.
With so many different notions of what growth and value are there is no wonder that many different growth and value index methodologies exist. Choosing the one that is right for you will depend upon the application. A useful parallel could be taken from money managers, who often refer to themselves as ‘top down’ or ‘bottom up’ managers. If they generally first look at a group of stocks with common characteristics and then pick individual holdings they are working from the top down. Those that generally pick stocks one by one are building portfolios from the bottom up. These concepts also have a value in the world of indexed investing.
If one is choosing an index or a group of indexes to benchmark a group of active managers that tend to want to be all things to all people one might prefer an index that has been designed to divide the markets in a more general way, or top-down. That way no matter what the manager says he is as far as being a growth manager or value manager. You can compare his holdings and get a general idea of his true leanings. A generalised index that divides the market into two equal amounts of capitalisation, for example, would probably experience market volatility more in line with the total market. In theory generalised indexes would have some growth securities in its value index or some value securities in the growth index.
However, if one is trying to build a growth and value investment vehicle to be used for market timing or as the basis of futures contracts, a generalised index could work against you. In this case you will make a bet on growth or value going up or down and your profit would depend largely upon the size as well as the direction of the volatility. The best-case scenario for this investor would be to use the index methodology that included stocks that were up the most when the style was in favour and down the most when the style was out of favour. Such methodology most likely would be one that used multiple factors to determine the growth or value assignment of individual stocks and that was at least indirectly influenced by the current market expectations. Therefore, an investor that uses indexes as investment vehicles would be far better served by an index that used a ‘bottom up’ approach.
It does not behoove an index investor to do asset allocation based on broadly developed indexes. If you allocate assets other than equally among growth and value you are making an active decision to reduce one style allocation and increase the other. Instinct may rightly tell you that by using a less-volatile, top-down index you are protecting yourself in case you are wrong; the problem is that you must use significantly larger allocations to achieve the same returns as the more volatile bottom-up indexes even if you are correct, causing increased turnover. The cautious indexed investor would be much better served by using more accurate indexes and making fewer and smaller allocation decisions.
Lars Hamich is executive director of global business development at Dow Jones Indexes in Frankfurt