Understanding Investment Styles | Nasdaq
OWe recently discussed how bonds and equities will fall in 2022, with US stocks (NQUSB™) down 21% and US bonds (AGG) down 15%. We also showed how these returns were boosted by rising rates in response to inflation.
What is more interesting is how some types stocks have performed better (and worse) than the broader market. So-called “value” stocks outperformed “growth” stocks and (to a lesser extent) small stocks somewhat outperformed large stocks.
Today we look at different ways to segment stocks and construct portfolios that could outperform the market during specific periods.
Chart 1: Value and small-cap stocks outperformed the broader market last year
How do portfolio managers pick stocks?
It’s the job of many mutual fund portfolio managers to try to build portfolios that outperform the market in general. They do this by picking stocks that they think will perform better given the changing economy and corporate earnings.
Some portfolio managers analyze each company’s accounting statements and business opportunities separately to see which companies are likely to perform better in the future.
But others classify stocks based on groups of similar characteristics called factors.
Some of the most common factors are available as ETFs and include:
- Cut: Comparison of small cap companies and large cap companies.
- Style: Value companies are expected to give good returns relative to their initial investment, while growth companies are expected to grow faster, which should make a stock more attractive for investment.
- Momentum: Watch if a security is up or down, with the hope that the trend could continue.
- Quality: Usually looks at more fundamental metrics, such as leverage, management, and earnings stability.
Table 1: Common factors used to segment stocks
Today, we focus on the most common factors: size and style.
How does “Size” work?
Size is the easiest factor to understand since most of us know which companies are big and which are small. Size as a factor is usually based only on the market capitalization of the stock.
Large companies have certain advantages – they often dominate their industries, giving them more economies of scale and more customers. A stronger balance sheet can also reduce financing costs.
However, being smaller can also be an advantage. Often there are more opportunities to increase revenue and expand to new customers. Smaller management teams can also facilitate innovation with new products or at least focus on exploiting market niches.
For an example of how size portfolios can be constructed, our blog last week looked at how different ETFs cover the market cap spectrum of the Nasdaq-100®. With ETFs tracking the large-cap Nasdaq-100 (NDX), mid-cap Nasdaq Next-Gen™ (NGX), and small-cap Nasdaq Innovators Completion™ (NCX) (Chart 2). Chart 2 also shows that larger companies have more daily trades, which can make it difficult to build small-cap portfolios.
Chart 2: Range of market capitalizations of Nasdaq-listed securities, colored by constituents in portfolios of different sizes
How does “Style” work?
Style, on the other hand, is usually determined based on more detailed company-specific accounting data.
Style is generally divided into “value” or “growth”, but in reality, what makes a company a growth company is different from what makes it a value company. For example, the Nasdaq indices:
Rating a business for growth based on:
- Higher historical sales growth rate
- Higher historic earnings growth rate
- Price momentum, which will capture market expectations for future growth
While the accounting data used to assess companies in terms of value is different:
- Lower price-to-pound ratio
- Low sales to business value ratio
- Lower price-to-earnings ratio
In theory, with a value company, every dollar you invest buys you more underlying assets, sales, or profits than other companies offer. It’s similar to how you might think about buying a house or a car; you want more features for the same price.
In contrast, a small business with no current profits would appear to be of poor value based on historical profits. But if they become one of the biggest companies, their future earnings could justify a significant valuation. Since stock markets are good at gauging these future expectations, companies that are expected to grow faster generally cost more per unit of historical earnings (they have higher price-earnings multiples).
How to design factor portfolios?
As the economy and consumer trends change, this often creates opportunities that benefit specific types of businesses.
For example, we saw above that rising interest rates affect growth companies much more than value companies. We’ve also found that global events make energy companies more profitable, helping them outperform. And during Covid, we’ve seen consumer behaviors change in ways that have benefited businesses offering non-touch services versus in-person services.
In fact, if we look over long periods of time (Chart 3), we see that the style and size factors tend to have years of outperformance and underperformance. We also clearly see that the turning points in the performance of different factors are different, indicating that different underlying drivers alter the returns of different factors.
Chart 3: Styles are in favor and out of favor
US Factor-Rated ETFs
We mentioned earlier that there are a number of US equity ETFs that allow investors to make factor investments. In fact, if we look across the spectrum, almost any ETF can be classified as a combination of size and style.
In Chart 4 below, we attempt to categorize all US equity ETFs using a technique called Return-Based Style Analysis (RBSA).
First, we look at the returns of four Nasdaq-style indices (large-cap growth, large-cap value, small-cap growth, and small-cap value) that were constructed by ranking the underlying companies in each portfolio on the help from the fundamental measures that we have discussed. above.
Next, we mathematically regress each ETF’s returns against the four Nasdaq-style indices, with some constraints. The closer a portfolio’s returns match each of these underlying indices, the closer that ETF is to the wedge representing that index.
Applying this technique shows that the range of all US equity ETFs also represents a range of exposures to size and style factors. A ticker like:
- XLE (the ETF of the energy sector) is currently highly valued but also very large cap (lower right corner).
- FTCS (tracked by a capitalized index) and RDVY (tracking companies with rising dividends) also have a bias towards larger capitalization stocks.
- QQQ (tracked Nasdaq-100) has a large-cap growth slant (top right), while QQQJ (next in line for NDX) has a lower incline compared to QQQ while maintaining the overall growth incline.
- IWMthe market-wide Russell 2000 index fund is on the left (small) but almost on the axis (highlighting the mix of small-cap value and growth companies in its index).
- QUALITYdespite stock selection based on balance sheet stability measures, is in fact a large-cap growth portfolio.
- YOLOthe ETF designed for MEME stock traders, has a very small capitalization but also has a fairly high growth score.
Chart 4: US ETF ratings across the size and style spectrum
Also note that the (ETF) circles in Chart 4 are colored by the relative performance of 2022 against a “total market” index (NQUSB, the Nasdaq US Benchmark Index™).
There are roughly the same number of green (overperformance) and red (underperformance) circles. We also see that in 2022 most of the green was at the bottom of the chart. This shows how the value factor has dominated the growth factor when interest rates have risen. However, some growth ETFs still outperformed, such as ICLN (with exposure to Biden’s clean energy initiatives) and MOAT (which has companies that are attractively priced but also have enduring competitive advantages).
What does all this mean?
Using some of the same techniques that professional investors use to construct portfolios, we can rank ETFs by factor exposure. This shows that although there are thousands of ETFs out there, most offer a different combination of exposure to just these two factors (size and style).
We know that the ETF market ranges from vanilla index portfolios to ETFs with more complex stock selections. This diversity of ETF exposure benefits investors because it allows them to gain targeted exposures based on their investment preferences and view of the economy, helping them build portfolios of ETFs that could also outperform the market.
Of course, there are more factors than size and style, but we’ll save that for another day!