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Substance over style?

Why an agnostic approach beats equity style biases.
David Cumming Aviva Investors, 30 September 2019

Investors would be better served seeking opportunities from across the equity market than anchoring themselves to ideological style biases, argues David Cumming.

For active investors, it is important that their philosophy and processes are seen as effective and sustainable by clients. As the future is clearly not equal to the past, there is plenty of evidence that active equity investors can outperform if they have the correct processes.1 The key is that they can effectively direct their resources to assessing what is changing and judging future outcomes better and more profitably than the obviously non-dynamic passive investors or backward-looking exchange-traded funds.

Investment-style biases are often used by managers to reinforce consultants’ or clients’ belief in their ability to achieve superior returns and differentiate themselves from other managers. Styles such as value, growth, quality or momentum tend to feature as process variations.

However, there are a number of problems with style biases. Most obviously, they restrict the pool of stocks you can own, and consequently your investment opportunities. In a world where a lot of investors are driven by macro rather than stock specifics, this can lead to style-biased investors fishing in a pool where growth stocks are overvalued while value stocks are cheap, or vice-versa due to an excessive focus on macro drivers such as currency movements or bond yields. Their philosophical constraints prevent them from investing elsewhere.

Style biases also leave portfolio managers at greater risk of smart beta challenge or tighter portfolio management hurdles. This is particularly the case where the approach is formulaic enough to be algorithmically expressed via a smart beta strategy, replacing a quality value strategy, or where their performance can be measured against benchmarks reflecting their factor biases.

Instead, we favour a style-agnostic approach. As active, stock-driven and future-focused equity investors, the best way to deliver for clients is not to constrain your investment opportunity set, nor your ability to respond to changing trends or information flows, both at the micro or macro level. This is especially relevant when competing against non-dynamic alternatives.

Style drift

A style-agnostic approach allows portfolios to simply follow the best fundamental stock opportunities, whatever the ‘style’ implications. This gives us the widest opportunity set to choose from and to have style ‘drift’ within portfolio construction. It also avoids the risk that macro factors may impinge on style performance at different points in the investment cycle.

Furthermore, being style agnostic leads to less factor or thematic volatility due to the sector biases inherent in various investment styles. Growth, for example, is often associated with being overweight technology. It should also diminish the risk of ‘anchoring’ – in other words, favouring one particular stock or sector. Changing portfolio exposures to a changing environment are allowed to be more dynamic under a style-agnostic philosophy.

Style-agnostic, idiosyncratic stock selection cannot be expressed by smart beta, ETFs or passive strategies, and its performance hurdle cannot be tightly constrained. Also, style-agnostic portfolios will remain relevant throughout the cycle, with less client churn as the investment cycle progresses and style ‘boxes’ fall in and out of favour.

Intellectual shortcut

In conclusion, there are a lot of factors that have to be in place to encourage clients away from the passive option. Committed, well-resourced investment teams, a common investment approach, clear communication structures, efficient portfolio construction and the scale to directly access company management are all advantages. Having a style bias is not.

Style bias is simply an intellectual shortcut that restricts the opportunities created by market inefficiencies; a way of limiting your universe (and your workload).

However, if you have the analytical resources and organisational agility to cover the investment universe, you don’t need shortcuts and can focus on first principles. Look for situations where company fundamentals are mispriced, and when these fundamentals transpire you make money. This flexibility offers a clearer and more efficient delivery of the truth that the future is not equal to the past, which is the nemesis of passive investing and ‘smart’ beta. Style biases simply get in the way.



References

1KJM Cremers & A Petajisto ‘How active is your fund manager?’, The Review of Financial Studies, 2009 (probably the most cited study in this area)

David Cumming, Chief Investment Officer, Equities and Head of UK Equities