In my previous three articles, I have considered the various elements of fund style including the underlying philosophies backing the strategies and some of the common differences in approach, as well as highlighting some of the most highly rated funds in each area. In this final piece on style, I wish to focus on style rotation and the opportunities for fund selectors to tilt their portfolios towards certain areas.
Certainly, early in the bull market following the credit crisis investors were presented with a compelling opportunity to bias portfolios towards quality equities. Quality businesses, which almost by definition have less sensitivity to economic growth, understandably outperformed during the bear market and subsequently lagged in the recovery that began towards the end of the first quarter 2009.
Value stocks, of course, led the market higher once this inflection point had been reached. As the dust began to settle, it became clear that the world was entering into a new economic paradigm as it adjusted to the shock caused by the near collapse of the global banking sector, the plunge in interest rates to unprecedented levels and the introduction of QE. The world was in unchartered economic waters and central bankers were forced to make decisions based upon widely contested theories.
Given these circumstances, it seemed natural for investors to favour investments that offered a degree of stability in a very uncertain world. Companies with established franchises, stable cash flows and strong balance sheets seemed particularly attractive options. I built positions in funds such as CF Woodford Income and Morgan Stanley Global Brands during 2009 and 2010, surprised that I could access portfolios full of quality stocks that were trading at a significant discount to the market average.
As we know, quality stocks have enjoyed a marked re-rating since then. Indeed, such has been the revaluation that some investors have suggested that prices of bond-proxy equities have moved into bubble territory. Conversely, certainly until the first quarter of last year, value stocks became evermore cheaper. These are interesting trends to follow but I suspect that many fund buyers struggle to monitor how valuations of different style groupings change. In the past, I have resorted to following the portfolio valuation of a handful of stylistically ‘pure’ managers to gauge an approximation of how the market was pricing stocks.
Fund buyers may be aware of Research Affiliates, who provide smart beta strategies for institutions and ETFs. Rob Arnott and his team have issued several fascinating articles over recent months about the importance of valuation when assessing the merits of smart beta strategies. They highlight that a number of factor-based approaches that have historically generated excess returns have only done so because the market has rerated certain types of stocks over an extended period. This makes intuitive sense. If quality stocks have been re-rated higher, which is something that has been going on for over 20 years, we perhaps should not be too surprised if these stocks have generated excess returns over the period.
Helpfully, Research Affiliates now publish a chart detailing the current valuation metrics of various factor-based strategies and style groupings. The metrics compare the current valuation to the historical range and provide the user with a quick and simple way of gauging how stock groupings are being valued within markets. The chart includes details of the firm’s RAFI smart beta fund range. This is a fantastic piece of work and is a valuable resource available to anyone building fund portfolios.
Jason Broomer head of investment at Square Mile