In our previous blog, we highlighted the contribution to domestic equity market returns by mega-cap stocks in 2017 and the implications for active management. In this blog, we focus our discussion on investment style classification. Specifically, we analyze the impact of the style classification scheme on managers’ performance analysis, such as in the SPIVA® U.S. Year-End 2017 Scorecard.
A managers’ investment style is the philosophy and process in which they have stated they invest by (a characteristic guideline of acceptable investments). Moreover, investment style sets the evaluation framework through which managers’ performance and risk exposures can be measured.
Traditional “style box” investing divides investment styles along a size and fundamental valuation metrics spectrum. Exhibit 1 shows the returns of the nine S&P U.S. Style Indices over various trailing one-year periods, ending each June and December since 2015. The returns are color coded so that the darkest color indicates the best-performing style, and the lightest denotes the opposite.
As of Dec. 31, 2017, large-cap growth performed the best, while small-cap value performed the worst. The remaining styles fell in between those two categories such that shifting across the market cap range or style (as shown by the row or column, respectively) allowed for potential additional return pickup. For example, small-cap value managers would have performed better had they owned mid-cap value securities or moved closer to small-cap core.
The direction (of the green hue) and magnitude make a big difference in whether the managers of a certain style box had a better (or worse) opportunity to outperform their stated benchmark by moving styles. With respect to the direction of the green hue, one might conclude that in 2016, large-cap managers could drift down in capitalization to harvest the size premium (Exhibit 1, center table).
While style drift can potentially offer return opportunities for managers who can time correctly, there are limitations to such a decision. One potential restriction stems from the classification rules set forth by the fund ranking providers for each style. For example, according to Lipper style classifications, large- (or mid-) cap managers are defined as funds that invest at least 75% of their assets in securities that are larger (or smaller) than 300% of the 750th largest security in the S&P Composite 1500®. Similarly, small-cap managers are those that invest at least 75% of the assets in securities that are smaller than 250% of the 1,000th largest security in the S&P Composite 1500.
The result is that large-, mid-, and small-cap managers have an opportunity set that is roughly represented by the 400 largest, 400th largest and below, and 600th largest and below stocks, respectively (see Exhibit 2). In other words, mid- and small-cap managers have more autonomy to express their view on the size factor without officially “drifting” outside of their defined style classification.
Therefore, depending on the market cap cutoffs used by the benchmark providers, there may be a mismatch between the funds and the benchmarks they are compared against. This blog serves as a foundation to our next discussion in which we will attempt to quantify this mismatch in style using mid- and small-cap managers as an example. Furthermore, we will discuss how to address the comparison bias through index construction.
Market participants should use this blog not solely to identify potential market environments in which style classification may be most influential, but also to prompt further investigation into whether their managers’ returns are style-consistent so as to set proper risk/return expectations. We show that there may be significant cross over between style boxes, and thus a given manager’s style should not be taken at face value.