How’s your investing style?
The growing mutual funds industry owes its numerical growth partly to the assorted investing styles applied by capital managers. Research shows that investing styles greatly influence fund returns, fanning the debate in the financial community about their effectiveness. Here are the major styles utilized by contemporary fund managers.
Passive vs. Active
Passive investors believe that simple investments in a market index fund can create productive long-term benefits. Active investors, in contrast, trust their capability to overtake the entire market by picking promising stocks. The bulk of mutual funds performed below market indexes within the five-year period which ended on December 31, 2015.* Passive investors explain the result on market efficiency, the theory that considers all information reported regarding a firm is represented in that firm’s present stock price; and that it is very difficult to predict and benefit on forthcoming stock price levels. Instead of trying to divine the market performance, what passive investors do is to buy the whole market through index funds.
Active investors, in contrast, believe that managed funds will not always perform below the index level of the overall market. So many funds have attained substantially higher revenues. These active players see the market as not always efficiently running and that with research they can discover information not yet obvious in a security’s price and thereby gain from it. For instance, some active investors consider small-cap market as being less efficient than large-cap market because smaller firms, in practice, are not monitored as regularly as bigger blue-chip companies. They explain this by the assumption that a less efficient market could prospectively favor active stock selection.
*Source: Standard & Poor’s, S&P Indices Versus Active Funds (SPIVA®) Scorecard, Year-End 2015. In the five-year period going to 12/31/2015, 84% of large-cap funds did not outperform the S&P 500 Index, 77% of midcap funds performed below the S&P MidCap 400 Index, and 90% of small-cap funds also underperformed the S&P SmallCap 600 Index.
Value vs. Growth
There are two kinds of active investors: growth and value hunters. Defenders of growth look for firms that can (on average) improve returns by 15% to 25%; although there is no certainty that this goal will be attained. These firms’ stocks usually have high price-to-earnings ratios (P/E) as investors shell out a premium for better revenues. And they often pay low dividends, if at all. This can result into more volatile growth stocks with greater risks involved.
Value investors, on the other hand, hunt for low-priced investments — bargain stocks which are usually out of favor, for instance, cyclical stocks dwindling at the tail end of their business life. A value investor is generally pulled into buying asset-based stocks with low prices vis-a-vis fundamental book, liquidation or replacement values. Value stocks, likewise, often have characteristically lower P/E ratios and higher prospective dividend benefits. These promising higher returns often protect value stocks in down markets, whereas some cyclical stocks will lead the market after a recession.
Some investors prefer a more free style by choosing not to be locked into any single investment style. Revenues from growth stocks and value stocks often tend to be closely connected. That is, a decrease or increase in either can produce negligible effect on the other. By choosing to diversify between value and growth styles, investors can manage risk more effectively and still hope to gain potentially high, long-term benefits.
Small Cap vs. Large Cap
In other cases, some investors look at the size of a firm before investing. Research shows that stock returns way back in 1925 suggest that going “smaller is better.” In general, small-cap stocks have overtaken large-cap stocks over the long-term durations. However, as these returns often go through cycles, there were long durations when large-cap stocks did better than smaller stocks.
Small-cap stocks also go through more price fluctuations, leading to greater risks. Choosing the middle road, some investors choose to invest in mid-cap stocks with have market capitalizations from $500 million to $8 billion – finding a trade-off between return and volatility. By doing this, they give up the promising returns of small-cap stocks.
Sources: Standard & Poor’s; Center for Research in Securities Pricing (CRSP). Large-cap stocks are represented by the S&P 500 Index, an unmanaged index often considered representative of the large-cap, U.S. stock market. Small-cap stocks, on the other hand, are represented by a composite of the CRSP 6th-10th decile portfolios and the S&P SmallCap 600 Index, unmanaged indexes that are often considered representative of the small-cap, U.S. stock market.
Top-Down vs. Bottom-Up
A top-down investor observes initially economic influences and then chooses industries correspondingly. For instance, at low-inflation periods, consumer spending rises, a good time for purchasing retail stocks or automobile stocks. A top-down investor would therefore look for the highest values in such companies. In contrast, a bottom-up investor is chooses to consider the individual firm’s fundamentals. They believe that even if its industry is down, a hot company can still overtake the market. Both styles highlight fundamentals but put contrasting focus on the economic climate.
Technical vs. Fundamental Analysis
Then there is the difference between some equity investors in terms of the fundamentals of individual stocks and their technical characteristics. Fundamentalists, who outnumber technical analts, focus on yearly reports and visiting firms in trying to discover investment potentials and higher potential returns in the long haul. On the other hand, technical analysts closely monitor charts of stock prices and economic information to try to discover patterns which can predict future trends. They are more into observing short-term market performances instead of picking individual stocks.
While technical analysts have failed to gain more adherent due to their questionable forecasting abilities, enhanced access to information and the rising capability of computers have driven greater interest among investors.
Asset Allocation: A different form of investing “style”
Asset allocation has become an acceptable form of investment style. Investors who are considered market-timing purists move in or out of particular types (bonds, stocks and money markets1), according to the projections of their technical models. A safer method, dynamic asset allocation, applies risk/return trade-offs to decide which class of assets to choose. Nevertheless, asset allocation does not ascertain success or safeguard against loss.
If bonds are deemed “cheaper” than stocks, then allocation will work in favor of bonds. Those who allocate their assets regularly adjust their portfolios according to the market and economic environment.
1An investment in a money market fund is not guaranteed or insured by the Federal Deposit Insurance Corporation or any other government agency. Although the fund seeks to preserve the value of your investment at $1.00 per share, one can lose money by investing in the fund.
Choose diversification when in doubt
Many experts recommend diversification in order to manage fluctuations in the market as another investment style. Mutual fund investors have to do research and ask valid questions, read the fund prospectus carefully, and seek advice from fund-rating services to ascertain that they are buying a style that is right for them. You now have to decide which one — or which ones — of these styles is suited to your personal situation. Seek the assistance of an investment advisor help you go through the process of unraveling the issues in order to come up with your own unique style.