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Size and Value Never Go Out of Style
How the Morningstar Style Box provides investors with a foundation for a long-term portfolio
Investors have analyzed managers and portfolios with “style
analysis”—particularly holdings-based style analysis, as presented by
the Morningstar Style BoxTM—for many years. The style box
showcases funds on two distinct planes or dimensions of returns—size
and value. Since the style box’s launch in 1992, many other dimensions have
been discovered or purported to have been discovered. We count over
160 published anomalies in equity markets, and we suspect this is an
underestimate. But not only is the importance of these factors
debatable, they may also not survive the test of time and market. We
see this in R. David Mclean and Jeffrey Pontiff’s recent study of 97 factors, which found that a factor’s
profit declines following its academic publication. About two years ago, we introduced a 36-factor visualization based
on the Morningstar Global Risk Model for those
investors who want to dig deeper. BlackRock is apparently following
suit with a “Factor Box,” which seems loosely comparable to our risk
model visualization. Based on how BlackRock describes the Factor Box, one
might think that size and value don’t matter in equity markets
anymore. That couldn’t be further from the truth (or the data). At Morningstar, we don’t see additional factors or sources of
return as competition to traditional value/growth and size styles.
Rather, we see them as complements that can be very useful secondary
sources of information for investors to carefully consider. In the
asset-pricing parlance, we see them as orthogonal dimensions of
return. Despite the well-documented existence of other factors, we
still believe that a style box should seek to give the foundation for
a long-term portfolio allocation to investors. That should mean
defaulting any style box to the planes of size and value.
So as a broad guide, the Morningstar Style Box simultaneously tells
you something about the fund employing the style, as well as the two
biggest explainers of long-term equity returns, size and value. After the development of the Morningstar Style Box, more factors
have been established in the academic literature. We capture several
of them in our risk model, particularly momentum, volatility, and moat
or stock quality. But these measures aren’t as important to understand
an active manager’s behavior. We can talk sensibly about a value
manager, or a small-cap specialist, or indeed a small-cap growth
specialist. Very occasionally, you hear about particular managers as
momentum specialists. But no managers call themselves “low volatility
specialists” or “liquidity specialists,” let alone a “low-volatility,
liquidity specialist.” There’s an argument to bring in momentum as a dimension, and
investors should certainly be live to momentum exposures in their
portfolio. But the track record as an investment strategy sometimes
experiences spectacular reversals. Historically, it has generated
magnificent and consistent returns from 1940 through 2000 in U.S.
equity markets, explaining substantial portfolio variation. But since
then, performance has been much less consistent, with a massive
reversal in the 2007-08 crash. We think paying attention to other well-established factors is
useful for portfolio monitoring, but we are a little worried about how
they will be used. There is something of a cautionary tale in sector
rotation and more general tactical asset-allocation strategies. These
were popularized in the 1990s. The idea is that macroeconomic cycles
tend to make particular sectors boom and bust, and particular sectors
are identified to be the ones to “get into” in particular conditions. For instance, in the “full recession” stage of the economy,
technology is meant to be oversold, and therefore a good idea to
deliver excess returns. Tactical asset-allocation generalizes this
idea, and managers rapidly shift between asset classes based on macro
forecasts or trend-following.
Morningstar’s Jeff Ptak notes that tactical
funds generally have failed to deliver better risk-adjusted returns,
or downside protection, than do traditional balanced index portfolios. And hence the worry—investors note that momentum strategies did
very well in 2017, so load up on momentum. Or low volatility. Or
whatever flavor of the month. Or more generally try to dynamically
modify their portfolio to generate outperformance. Perhaps this
strategy works sometimes, but it is certainly hard to execute well.
More factors present investors with more flashing lights, something
else to tactically shift over and thus generate trading costs and
manager fee revenue, but not investor outperformance. Size and value,
on the other hand, have proven to withstand the test of time and popularization.Patrick Caldon
For investors who want to dig deeper
Morningstar Style Box Morningstar
Global Risk Model Visualization
Why do we talk about style? Here are two reasons.
New factors keep coming
Can we use factors other than size and value?
To access the Global Risk Model data
points, try Morningstar Direct.