Style-based investing remains a significant part of portfolio construction in the United States. For years, US-based investors have constructed portfolios based in part or entirely on the basis of investment style. However, despite the widespread acceptance of style investing across the Atlantic, European investors, with few exceptions, have yet to embrace the approach.
Theoretically, there is no reason that the size and value effects that have been so well documented in the US could not also operate elsewhere. In fact, there has been some research to support that these effects have presented themselves in other markets. For example, a study published in 1996 concludes :
“Recent research for the US market shows that two risk factors, value and size, explain differences in expected returns across equity performance. Preliminary evidence suggests that the same factors also work in foreign markets.” (Rex A. Sinquefield, “Where Are the Gains from International Diversification?” Financial Analysts Journal, January-February 1996.)
Nevertheless, style indexes have not gained as much popularity in Europe as they have in the US. Historically, there is good reason for this. Until recently, equity markets in Europe have been fragmented, with many investors possessing a strong home-country bias. Such fragmentation causes a practical problem with creating style indexes. Many single markets are heavily concentrated in a few large companies, and as a result, the “large” capitalisation group contains only a few stocks and there is little room to further divide into “value” and “growth” groups.
That is changing. Europe as a whole is becoming more integrated. With virtually all of the developed European countries participating in the European Union, and the majority of the largest economies being part of the Eurozone (the notable exception being the United Kingdom), Europe is poised to function as a more integrated market. Hence, we think it makes sense to view Europe as a whole for the purpose of creating style indexes. In this case, the stocks of all the largest companies across Europe belong to the large-cap group, and there is adequate room to distinguish between value, core, and growth stocks.
Morningstar has introduced a family of pan-European style indexes mirroring their US counterparts, and with an inception date of 30 June 2003. Figure 1 shows the cumulative value of investing €100 in each of the nine style indexes since inception through 30 June 2010, with all dividends reinvested and no taxes. While this is not a very long period to study style trends, it is interesting to notice the style effects that were manifested over this period. Firstly, there was a size effect, with small-cap stocks outperforming mid-cap stocks and mid-cap stocks outperforming large-cap stocks. Secondly, within each market-cap band, there was a value/growth effect, albeit in different directions across the size bands. For large-cap and small-cap stocks, growth stocks outperformed core stocks and core stocks outperformed value stocks.
Furthermore, as Figure 2 shows, the better performing styles did so with lower volatility within each of these size bands. However, things were quite different in the mid-cap band. Here, value stocks outperformed core stocks and core stocks outperformed growth stocks, the opposite of what happened with both large-cap and small-cap stocks. Additionally, as Figure 2 shows, outperformance was accompanied with increasing rather than decreasing outperformance within the mid-cap band.
These results demonstrate that even over a period shorter than a decade, style effects can be important enough to matter to investors in European stocks. This is why I believe that investors in Europe could benefit by looking at equity portfolio construction through the prism of style.
A version of this article was first published in Investment Adviser on February 8, 2011.
