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Style Is Never Out Of Fashion

7 min read


Tom Goodwin is Senior Research Director for Russell Indexes.

Tom Goodwin, PhD, is Senior Research Director for Russell Indexes focusing on helping clients utilize Russell index tools to better understand capital market dynamics, more accurately measure market and portfolio performance, and gain efficient exposure to investment styles, market capitalizations or asset classes. In this email interview with SmartBrief, Mr. Goodwin discusses style index leadership as the market looks towards Smart Beta.

Question: What’s the history of style indexes and the style box? Which one came first?

Tom Goodwin: The late 80s and early 90s was a time of tremendous growth in both technology and financial reporting. These developments were an evolution, with multiple influences converging across business and financial services. Although they are practically household words in 2014, in the 80s, growth and value were new. Growth and value investing had just become industry buzzwords, and consultants and analysts were beginning to study sources of portfolio return. It is out of this environment that Russell Investments first introduced its methodology for growth and value style indexes in 1987.  Russell’s style indexes became the most widely used growth and value indexes in the industry. It is the creation and wide availability of these indexes that helped spur the development of broader reporting and data visualization strategies, including the style box.

Q: What differentiates Russell’s approach to style index construction? Is there any security overlap in Russell’s style categories?

TG: Russell’s style methodology uses one value characteristic —  book-to-price ratio (B/P) — and two growth characteristics — medium-term forecasted earnings growth rates based on the I/B/E/S two-year forecasts and sales-per-share growth rates, based on five-year historical sales. Stocks are sorted by their value score and growth score, which are then combined to form a composite value score (CVS). Because some companies can exhibit a mix of value and growth characteristics, each stock is assigned a growth and value probability based on its CVS.  The probability indicates the degree of certainty that a stock is growth or value, or a blend of the two.  Roughly 70% of stocks are classified as all value or all growth, while 30% is weighted proportionately to both value and growth.

For example, as of December 31, 2013, the Russell 1000 Growth Index included 625 constituents and the Russell 1000 Value Index held 662 constituents. Approximately 270 companies were held in both indexes, with a portion of their total weighting assigned to each style index.  The indexes are modular, so that the Russell 1000 Growth and Value Indexes roll up to equal the Russell 1000.

Other index providers use six, eight or even 11 different growth and value characteristics in an attempt to increase representativeness. But Russell research indicates that using a smaller number of variables produce indexes that best represents style portfolios held by investment managers while also controlling turnover.

Q: With so much attention focused on “smart beta” — alternately weighted index strategies — is there still a role for Growth and Value?

TG: Absolutely. At Russell, we consider Growth and Value to be the first smart beta indexes. The methodology outlined above calculates stock weights by multiplying the probability of growth or value by the capitalization, and grosses up those values to sum up to 100%.  The net results are weights on stocks that can be very different than the weights in the parent benchmark, giving the investor an excellent capture of the factors.

Russell is at the forefront of developing the new family of smart beta indexes but there are challenges that come from being the new kids on the block including investor education about how to use the indexes, short data histories and liquidity issues. In contrast, Russell launched Growth and Value indexes almost 30 years ago. There are now $2.8 trillion in assets benchmarked to them, with about $178 billion in assets directly invested in Russell Growth and Value Indexes through mutual funds and ETFs. The high liquidity provided by wide adoption, long back history, and widespread investor awareness of Growth and Value make them a still-compelling choice for many investors seeking a factor tilt in their portfolios.

Q: There is a large body of academic research concluding that there is a Value premium meaning that value outperforms growth in the long run. Is Growth dead?

TG: Absolutely not. While Value tends to outperform in the long run, Growth can outperform for shorter periods of time depending on the stage of the investment cycle. For example, during the tech bubble of the late 1990s, Growth sharply outperformed Value. Growth also outperformed Value in the months immediately following the market bottom in March 2009.  Year-to-date (March 20, 2014), Growth has outperformed Value.[i]

Growth and Value investors tend to view the market differently. Value investors seek to find undervalued stocks that will likely return to their (higher) intrinsic value. And it may take patience to wait for this to happen. Growth investors focus on earnings growth and are willing to pay high multiples for expected growth they feel is not fully reflected in the current market price. The strategy is especially successful during optimistic parts of the cycle. In fact, as my colleague David Koenig has shown, there is a strong case to be made for passively using both Growth and Value indexes in a portfolio to smooth out the bumps of market cycles while still capturing a good part of the upside of each style.

Q: Depending on who you ask, there are some conflicting outlooks on Growth and Value in 2014. What is Russell Investments’ house view?

TG: I recently had an interesting conversation with Steve Wood, Russell’s Chief Market Strategist, about this subject. Classic value investing typically implies that one is looking for undervalued companies, usually defined as companies with high book-to-price ratios, and low growth and sales per share growth. Dr. Wood contends, “it isn’t a particularly cheap environment right now. Finding true value can be more challenging given current valuations.”

Our view is that we are in a later-stage economic growth environment and there have been no major economic changes refuting our perspective. Currently, Russell Investments maintains a muted growth outlook for U.S. equities in 2014. Dr. Wood remarks that, “as growth becomes more difficult to find, it could get bid up by active investors when identified.” With these complexities in mind, style choices become a portfolio risk conversation. What is the minimum risk required to provide returns in the timeframe you seek? In this market environment, he sees the benefits offered by Russell Value and Growth indexes in their ability to clarify these segments to provide transparent measurement, discipline and exposure.

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[i] Source: Russell Investments, as measured by the Russell 1000 Growth Index, Russell 2000 Growth Index, Russell 1000 Value Index and Russell 2000 Value Index.