Why You Should Care About Investment Styles

Investment styles explained

The recent September sell-off in tech stocks is much more than what it appears on the surface. In fact, if you look closely, the market is indeed undergoing some sort of routine style rotation, moving from one group to another.

We have in the past wrote about various type of investment strategies. One area that we have not previously discussed in-depth is the different investment styles in portfolio management today. More importantly, we outline the reasons why you should care about investment styles.

Our goal with this article is to bring forward two key ideas. Firstly, what are the different investment styles and how do you identify them. Secondly, how you can use this knowledge to be a better risk-taker in the stock market.

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    Investment styles explained

    Simply put, investment styles, also known as factor investing, refers to the way investors invest based on some sort of criteria or styles. Formally, this a disciplined and systematic framework of investing with the goal of producing long-term positive returns.

    Today, the common factors and styles you will have come across are growth vs value, high quality vs low quality, high beta vs low beta and large vs small cap. Nonetheless, in this article, we will try to summarize the above in four key groups.

    According to AQR, a leading quantitative investment management firm, the four classic investment styles in portfolio management are value, momentum, carry and defensive.

    Value investing

    Perhaps the best-known investment style, made famous by Benjamin Graham and Warren Buffett, value investing received the most attention among the various investment styles. The idea is simple: buying undervalued assets and selling overvalued ones.

    This strategy seek to dissect its fundamental value via measures such as cash flows, P/E, P/B ratios etc. A staunch practitioner of value investing, Warren Buffett has average an annualized return of >20% over his investing career. The difficulty, however, is identifying value stocks in the current setting. With unprecedented central banks intervention and sub-zero interest rate, identifying true value stocks has been increasingly challenging.

    Value investing is at its core the marriage of a contrarian streak and a calculator. Seth Klarman

    Momentum investing

    Momentum investing is another popular style. Momentum is the tendency of showing persistence in its relative performance over a period in time. Bottom line, winners are going to continue being winners, and vice-versa.

    In practical terms, the idea is to buy stocks that has outperformed while shorting stocks that has underperformed. In short, buy winners and sell losers.

    The quantification of momentum stocks does not need to be restricted to its own-price momentum. For example, this can be earnings momentum, variations in analyst ratings etc.

    Evidently, since the COVID-19 took center stage in March 2020, most tech / tech-related stocks exhibit extremely strong price momentum. Consequently, growth stocks are frequently associated with momentum stocks.

    Carry investing

    Popular among macroeconomist and FX enthusiasts, carry is based on investing (lending) in higher yielding stocks and financing the position by shorting (borrowing) in a lower yielding stocks. For example, going long a higher yielding stock, while simultaneously shorting stocks with lower yield, and banking in the difference, all else being equal.

    In stocks, carry investing is popular among market neutral long/short equity strategy. For retail investors, we regard carry investing as a more sophisticated strategy that should be applied diligently.

    Defensive investing

    Defensive investing concerns seeking for companies that exhibits low risk.

    For example, Frazzini and Pedersen, in their seminal piece “Betting against beta” shown that going long stocks with low forecasted beta and shorting the ones with highest beta yields positive risk-adjusted return. Extending the concept of low risk vs high risk, the idea of defensive investing can constructed via “quality”, “beta”, “leverage” etc.

    How to identify stock investment styles

    We drew up a general list of pointers to help you identify the type of stocks and their styles.

    stock investment styles explained
    Broad classification and identification of stock investment styles.

    How to be a better risk-taker in the markets

    Having identified and classified the relevant stocks, this provides us with another angle in our risk management framework. Using our portfolio as example, here’s how we would classify them.We are assuming equal weighting of stocks in our portfolio.

    Classification of stock investment styles
    Classification of stock investment styles based on our portfolio.
    Investment styles exposures
    Exposure analysis by investment styles.

    By design, the portfolio is constructed taking into consideration the exposure to various investment styles.

    Unsurprisingly, our portfolio is reasonably split among value, momentum and defensive. Long-time readers would have been aware that despite various investment styles rotation in the market, our portfolio continues to deliver growth and is less correlated to a particular investment style. See our past newsletters here.

    In our view, diversification is not solely about the number of stocks held in a portfolio, but also by investment style.

    One can argue that, in fact, investment styles largely dictates the trajectory of your portfolio. A rule of thumb is to seek the best stocks among different investment styles.

    Today, it’s not unusual to see that a significant proportion of millennials’ portfolio consist of primarily tech stocks, implying high gearing towards momentum stocks.

    The recent momentum meltdown has caused somewhat of a drawdown, which raised the question whether investors are actually betting on the company or unknowingly betting on the investment style itself.

    Summary

    The subject and discipline of investment risk management is constantly evolving. As style investing / factor investing become more prominent, evident from the explosive growth of style investing funds, it’s prudent for investors to be aware of the exposures of various investment styles in their portfolio, in our view.

    Here is a quick summary of our article

    • Understanding what investment styles are
    • Identifying stock investment styles
    • Enhancing your risk management via portfolio exposure analysis of different investment styles

    Risk management is often less about reducing a certain element, but to create the awareness and to help investors understand actual exposures relative to perception.

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