Jonathan Davis: Time to add a little bit of style to your portfolio

How many investors in the UK think hard about the way in which their portfolios of shares or funds are made up? In practice, it seems, precious few. Most investors make some buy-or-sell decisions once or twice a year based on what they (or advisers) think represents good value at that moment. Not many stop to look back at either the overall shape of their portfolios, which will inevitably get pulled out of balance as the years pass, or at the components of the returns that they have actually achieved.

How many investors in the UK think hard about the way in which their portfolios of shares or funds are made up? In practice, it seems, precious few. Most investors make some buy-or-sell decisions once or twice a year based on what they (or advisers) think represents good value at that moment. Not many stop to look back at either the overall shape of their portfolios, which will inevitably get pulled out of balance as the years pass, or at the components of the returns that they have actually achieved.

As a result, they end up being collectors of funds and shares, rather than, ideally, disciplined investors who know more precisely what bets they are taking and what risks they are running.

Such analysis, for those who have the know-how and patience to undertake it, can lead to surprising results. In the UK retail investor market, for example, it is well known that the majority of those who own shares tend to own just one or two, which they have typically acquired through privatisation or demutualisation. This inevitably gives them a lopsided set of holdings, and ensures their investments are more exposed to certain types of market conditions than others.

In the fund market, equally, the data suggests many investors are drawn like moths to a flame towards the beacon of high-growth funds, typically those that specialise in small to medium capitalisation shares, or, more recently, those with specialist mandates such as technology. The average unit trust in the All Companies sector has a very different set of characteristics to the stock market as a whole, being on average underweight in large capitalisation shares and having above-average volatility.

Why this should be so isa matter of debate. Some will say it is mainly the result of the tendency of new investor money to follow strong recent performance, regardless of the underlying investment merit of what they are buying. Others may prefer to look towards the financial incentives built into the commission-based advisory and intermediary system we operate in this country.

Experience suggests it is much easier to sell investors a fund that promises high growth - but has high charges - than it is to flog someone a conservatively managed and low-cost value fund, even though the latter in investment terms may prove to be a tortoise and the former a hare.

The one thing that seems certain is that most investors do not really appreciate exactly what it is they are buying. In the United States, where the concept of style investing and style analysis is more developed than it is over here, investors have a better grasp of what kind of share or fund they are buying.

One big question exercising professionals in the investment business in Europe is how far, and how quickly, investors can be persuaded to buy into this new way of thinking about investment in the UK. Schroders, for example, has launched a range of funds that invest according to certain style criteria, and many other groups are looking to market funds on a similar basis.

What is style analysis? It amounts to no more than breaking down and looking hard at the main factors contributing to the overall movements in a market. The same analysis can be applied to the behaviour of a particular fund manager. The most important "style factors" at work in a market are size (large versus small companies) and "value versus growth" effects. Other factors include momentum and gearing. Value and growth in turn can be broken down into several component criteria - high dividend yield and low p/e ratios, for example, in the case of value, and high returns on equity and so on in the case of growth.

On size, there is well-documented evidence that at different times markets tend to favour either large capitalisation or smaller capitalised companies. During these periods, the behaviour of a share will be influenced to a significant degree not just by its fundamental record of earnings, dividends and so on, but directly as a result of whether it has a larger-than-average, or smaller-than-average, market capitalisation. Investors who do not have the right kind of bias in their portfolios will be penalised, while those who do will benefit as a result. As for value versus growth, the distinction between a value share and a growth share has been talked about since at least the 1930s. But it has taken the advent of computing power - coupled with the research of a number of leading academics in the US - to turn this difference into a measurable characteristic that can be applied to whole portfolios and funds, as well as to individual shares.

In the US, most funds now market themselves explicitly by reference to a style matrix devised by the fund-rating company Morningstar. This is a device by which every fund is classified into one of nine style boxes, which are based on how a fund stacks up against the "large versus small cap" and "growth versus value" benchmarks.

In the UK, says Style Research, an investment research boutique that analyses the behaviour of markets and fund managers against sophisticated style criteria, there is evidence that the UK is starting to move down the path towards definable styles in the stock market. The graphs I show here are examples of how style analysis can illuminate what has been happening in the markets in recent periods.

The UK market has been dancing fairly consistently to a tune of growth, momentum and large cap stocks for most of the 1990s.

When the graphs slope upwards, they show a particular style factor has produced above-average returns relative to the market, while one that slopes downwards shows the opposite. So buying stocks with above-average dividend yields - a typical value criterion - has largely led to underperformance, while buying stocks with above average market capitalisation (a size effect) or strong recent share price performance (a momentum effect) has tended to produce above average gains.

As you can see from the charts, this well-established trend appears to have turned sharply in the last 12 months. Is this a blip or the start of a longer and more enduring trend?

Robert Schwob of Style Research argues that it is too early to be sure. The picture is mixed, and the style indicators may be reflecting a complex cross-current of underlying effects. What seems to be happening is that, after the tech stock shock, investors are hunting around for companies that have stable and reliable earnings growth regardless of other criteria.

The key for investors is that if the style barometer is set to change, the rules of the game of the last few years, which have overwhelmingly favoured a certain style of fund and share, will also change. I hope to return again shortly to this interesting subject, as my sense is that style factors are set to increase in importance and awareness over the next few years.

davisbiz@aol.com