Investment Styles Fan Longzhen Introduction ? Overview of investment styles; ? Empirical evidence on returns of small capitalization firms and value stocks; ? How to identify investment styles of a mutual fund – Characteristic-based style analysis – Return-based style analysis ? Style benchmarks ? Why value stock outperform growth stocks; ? Earning and price momentum Types of investment styles ? Growth investing – Primarily concerned with the earning component of the P/E ratio – Look for high growth rate ? Value (non-growth) investing – Primarily concerned with the price component of the P/E ratio – Look for cheap stocks ? Small cap investing (as opposed to large cap) – Looking for neglected stocks – Undervalued relative to large cap equities Investment styles ?Value: – low price/book; low P/E; utilities industry ? Growth: high EPS Growth – high profitability; health & technology ? Small capitalization Why style analysis? ? Returns of stocks in one category (e.g. growth) behave quite differently from stocks in another category (e.g. value) ? Style analysis facilities – Monitoring style characteristics; – Diversification and risk control; – Performance valuation ? In September 2001, a total of 3271 domestic equity managers participated in the survey – 962 identify themselves as value managers; – 1124 identify themselves as growth managers. Returns of small capitalization stocks ? Fama and French (1992) – Rank the stocks into ten deciles based on market capitalization every year; – Compute the average 1-year holding period return after portfolio formation. – Found small stocks have higher returns than big stocks (1963-1991) – Fama and French do a secondary sort by beta within each size decile, and find that beta can not explain the returns. Return of high/low book-to-market stocks ? Fama and French (1992, Journal of finance) – Rank stocks into ten deciles based on book-to- market ratio every year; – Compute the average 1-year holding period return after portfolio formation; – Value stocks have higher average returns than growth stocks. How to identify investment style of a mutual fund ? Characteristic-based style analysis; – Examine the portfolio holdings of a fund; – Compute the average style characteristics. value blend growth large lowest lowest medium medium lowest medium highest small medium highest highest Morningstar Fund Analysis ? Market capitalization classification – Step 1: rank all stocks based market capitalization ? Top 5% of the stocks as large cap; ? Next 15% of the stocks are medium cap; ? Remaining 80% of the stocks as small cap. ---step 2:assign a score of 3 for large-cap stocks, 2 for mid- cap stocks, and 1 for small-cap stocks. ---step3: calculate the weighted average of the market cap score across all stocks in the fund. ---Step 4: classification ? If market cap score<1.5 small cap fund ? If 1.5<market cap score<2.5 medium cap fund ? If market score>2.5 large cap fund ? ? ? Morningstar Fund Analysis ? Growth/value classification – Step 1: estimate mediam P/E and P/B ratio of the stocks in three market-cap groups; – Step 2 compute the P/E and P/B score for each stock: divide each stock’s P/E and P/B by the median P/E and median P/B (respectively) of the stock’s market-cap group; – Step 3 calculate the average P/E and P/B score for each fund: average P/E or P/B score is 1. – Step 4 combined score=P/E score +P/B score – Step5 classification ? If combined score>2.25 growth fund ? If 1.75<combined score<2.25 blend fund ? If combined score<1.75 value fund ? ? ? Return-based style analysis ? Based on multiple factor model: ? Where =return on fund ? = return on style benchmark k ? How to estimate the style exposure? – Regression of fund I on the return of style benchmarks; ? Unconstrained regression ? Constrained regression ( ) ? Quadratic programming ( ) iKiKiii eFbFbFbR ~ ~ ... ~~~ 2211 ++++= i R ~ k F ~ 1= ∑ ik b 0,1 >= ∑ ikik bb Return-based style analysis )var( )var( 1 2 i i R e R ?= 2 R reflects the return attributable to style ?Equal one if the model fits perfectly: there is no tracking error Selection= ? measure the component of the return attributable to derivations from the style benchmark. 2 1 R? Style benchmark ? Six style index – S&P 500/Barra growth and value – S&P midcap 400/Barra growth and value – S&P smallcap 600/Barra growth and value ? Growth and value indexes are constructed by dividing the stocks in the corresponding basic index based on book-to-price ratio. Each company in the index is assigned to either the value or growth index so that the two style add up to the full index. ? The growth and value indexes are constructed so that they have the same market capitalization. Since growth companies are bigger than value companies, there are many more companies in the value index than the growth index.