One of the major determinants of investment performance is that of the “style” adopted. Pension fund managers routinely allocate the funds they are entrusted with among portfolio managers largely on the basis of investment styles. Investors, as well, are finding the issue of style to be of increasing importance. Does style matter? It certainly does.

Style is the approach or concentration that a fund manager or investor uses in selecting stocks and constructing an investment portfolio. Style selection flows from beliefs about security pricing. The most basic style issue is that of passive versus active investment.

Passive Versus Active Styles

Passive investors believe that analysis of security and market information will not yield anything more than the normal returns one would get by randomly selecting a portfolio by throwing darts at a list of stocks. Adherents of this style pursue a pure indexing strategy and buy securities such as the “ i60s”- an exchange traded fund that tracks the S&P/TSX 60 index or index mutual funds. The passive emphasis is on constructing and maintaining an investment portfolio in the most cost-efficient manner.

Active investors believe that stocks can deviate substantially from their intrinsic values and that analytic techniques can be used to find undervalued securities. There are a host of different investment styles within the active framework. Some of the most popular style approaches are:

Value versus Growth

Value and growth have long represented the two basic approaches to fundamental security selection investing. Value style practitioners typically concentrate on finding undervalued shares trading at low P/E multiples or low price to book value shares. Value investors look for a substantial” margin of safety”; they look to buy stocks trading at substantial discounts (such as 50%) to their intrinsic value. Value investing is associated with such luminaries as Benjamin Graham, Warren Buffett and Sir John Templeton.

Growth style practitioners search for companies with strong growth potential; they generally concentrate on high P/E multiple stocks with strong earnings prospects. Technology companies are typically in the growth camp.

Although studies indicate that the value approach seems to outperform growth, value investing may mean unusually high volatility, and poorly diversified portfolios. One reason why the value approach has yielded higher return in the long run reflects the principle of “mean reversion”, a finding that important factors tend to revert or regress back to an average or mean value. For example, low P/E multiple stocks will tend to rise toward the average of all stocks over time while high P/E multiple stocks will regress down to the average.

Small versus large cap investors

Small cap investors concentrate on analyzing and selecting smaller companies typically those with market capitalizations of $250,000,000 or less; while micro cap investors concentrate on very small companies. Large cap investors obviously focus on the large TSX/S&P 60 -type companies. Cap rotators switch from small to medium to large cap stocks as market conditions change.

A number of studies have found the presence of a pervasive pattern for small companies to earn higher rates of returns in the long run than larger companies.

This “Small Firm Effect” is motivated by a number of possible factors. One explanation is risk. Stocks of small companies are more volatile than their larger counterparts. Hence, investors in small companies require a risk premium as compensation.

Another factor is the observation that small firms are often neglected or ignored. Small firms may lack popularity with large institutions and investors and/or may not be widely followed (some institutional investors are not allowed to invest in smaller-cap stocks). Some market commentators and newsletter writers are barred from discussing companies below a specified minimum capitalization. Accordingly, such stocks do not receive their fair share of attention and may become undervalued.

This “Cap Effect" is definitely cyclical. At times, the large caps outperform small caps. Periods in which the size advantage is negative are generally followed by periods in which it is positive.

The bottom line for your portfolio:

1. Style diversification is useful. As styles rotate in performance your portfolio will be properly balanced.
    

2. Avoid the bandwagon effect. Bandwagon traders are traders who are impelled to buy stocks that are well publicized and have made significant moves. These include “herd or noise traders” who follow the most recent stories in the financial press and buy whatever is in fashion. Avoid the tendency to buy into the latest style trend simply because it has been receiving excessive publicity. Consider following a buy and hold policy and avoid reacting to whatever styles are popular at the time.
    

3. Given the cyclical nature of the cap effect you should have a long-term (eight to ten-year) holding period for these investments.
    

4. Aside from its impact on return and variability, you also want to make sure your portfolio is not overly concentrated in a particular style since each approach has its unique characteristics. Furthermore, different styles perform better in specific market climates than others.
    

5. If you wish, you can trade all kinds of style indexes at present. There are exchange traded indexed products traded in the United States that cover a wide range of style indexes. Examples are cap indexes (such as the Fortune 500 tracking share), sector indexes (such as the Units S&P/TSX Capped Gold Index Fund), value and growth-based indexes (iShares Russell 1000 Growth and 1000 Value Indexes). All of the current style based products are passive or indexed ones.

Soon you will also be able to trade actively managed ETFS. The American Stock Exchange one of the true incubator exchanges (along with the Toronto Stock Exchange) is planning to introduce actively managed ETFs as soon as it gets regulatory approval.