Rethinking style diversification

This document is directed at investment professionals and qualified investors (as defined by MiFID/FCA regulations).

Investors frequently blend value and growth stocks with other assets, such as bonds and real estate, to potentially improve the risk and return profiles of their portfolios.

Since the performance of different types of assets or investing styles may not be correlated, the impact upon a portfolio of certain securities declining in value may possibly be offset by other securities generating gains. We believe that prudent diversification is important but based on the results of the past 10 or more years, we think the role of value equities in potentially improving a portfolio’s risk and return profile should be reevaluated.

The issue is particularly timely because investors have made substantial investments in value stocks. Of the approximately $9.3 trillion in U.S. equity mutual funds and exchange traded funds, only $2.9 trillion is allocated to pure growth equities with the remainder of assets being allocated to value or blended portfolios, according to Morningstar data.

The strong emphasis on value investing, however, has yielded disappointing results. During the past 10 years, diversifying into value equities would have achieved the opposite goal of diversification—a portfolio with both lower absolute returns and a less attractive risk and return profile. Value equities dramatically underperformed during the 10-year period, a result, in part, of various flaws in the value “philosophy” in our view. First, there is a reliance on valuation metrics, which are often based on outdated accounting practices that form the foundation of the definition of “value.” Second, and more importantly, investing according to “value” metrics tends to fail to appreciate the fundamental drivers of a company’s business. Value companies may be the victims of “dynamic change” in our economy and their industries. As a result, investors in the value style category often are heavily skewed toward companies with legacy business models and stagnant management and product strategies.

Value investors thus become investors in areas such as brick and mortar retailing, print and TV advertising companies or oil and gas energy that in the real world, where business fundamentals of growth and innovation come first (not financial valuation metrics), are becoming victims of change: the disrupted not the disruptors. We believe this dynamic change is being accelerated by the Covid crisis as well as other ongoing trends and will continue to hurt the performance of value stocks.

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