When it comes to style investing, pure style indices that select and weight securities based on their style scores tend to be less correlated with each other, have higher return spreads, and higher betas to the benchmark than the traditional market-cap-weighted style indices that have overlapping securities.
Additionally, when one style is favored over the other, the pure style version typically does better than the traditional style. The asymmetric performance and higher market sensitivity highlights the potential for pure style indices to undergo extended periods of underperformance than their style counterparts. Because of this, market participants often partake in style rotation (holding growth or value) or hold a combination of both styles to harvest style premium.
The decision to hold a combination of style indices or rotate entirely out of one style may come from a number of signals, ranging from valuation-based to macroeconomic conditions. In this blog, we do not attempt to discover signals for allocations; rather we take a simplified approach of computing hypothetical portfolios that combine pure value and pure growth at different weights.
To demonstrate this, we create 11 hypothetical portfolios by changing weights in 10% increments (going from 100% value, 0% growth to 0% value, 100% growth) based on the S&P 500 Style Indices. Exhibit 1 shows the annualized return and risk in a scatter plot (left chart) and the return/risk ratios (right chart) of the style portfolios from 1998 to 2018. Exhibit 2 shows the same analysis using the S&P Pure Style Indices.
Comparing the two sets of charts, for any given combination of growth and value, portfolios allocating to the pure style indices had higher return/risk ratios. For example, a portfolio with a 50%/50% mix of traditional value and growth had a reward/risk ratio of 0.40, while the same weight mix using pure style indices had a return/risk ratio of 0.50. Therefore, we are able to conclude that on a risk efficiency basis, the higher volatility in the pure style combinations is compensated by the additional return compared to style. The results point to the potential effectiveness of combining pure value and pure growth in the U.S. large-cap space.
Learn more about the S&P Style and S&P Pure Style Indices on Indexology®.