MONDAY MORNING: Style just isn’t the same, if you get my drift

Just when it seems that one investment style has taken over and will dominate the stock market for the foreseeable future, the market fools us.

Growth was dominant in the market from early 1998 until the end of the first quarter of this year – so dominant that value managers have been losing clients at a rapid rate as the clients surrender to the presumably permanently superior performance of the growth stocks.

Even some value managers have surrendered, at least partly, to the growth-stock phenomenon, becoming “relative-value managers” or “growth-at-a-reasonable-price managers. ” And many individual investors have given up on value funds and increased their commitment to growth funds.

But since spring, value has staged a comeback. Over the first nine months of this year, large-cap value stocks outperformed large-cap growth stocks by about 7 percentage points. The change serves as a reminder that no investment style dominates forever. There are distinct cycles.

The division of the equity market into growth and value stocks began in the 1960s and became entrenched in the mid-’70s. From the end of the 1973-74 bear market until mid-1981, value stocks outperformed growth stocks by substantial margins, so much so that growth stock managers began to lard their portfolios with value stocks showing higher price-earnings ratios.

clients displeased

That became known in the institutional investment field as “style drift,” and pension funds, the major institutional clients, didn’t like it.

The problem of style drift continued from 1985 to 1990, but during that time growth stocks outperformed value stocks, and some value managers sneaked a few growth stocks into their portfolios to improve the relative performance.

The 1992-93 period saw value again in the ascendancy, but by then pension funds, endowments and foundations were armed with quantitative tools to help them detect “drifting” managers. And they disciplined those who got out of line.

Why did they care? Why should anyone care if the drifting managers are providing better performance?

Because a drifting manager can undo an investor’s diversification and compound the risk.

Until recently, individual investors using mutual funds, and their financial advisers, were largely defenseless against drifting mutual funds. They had to either eyeball the mutual funds’ holdings when they became available or rely on Morningstar Inc. and other such services to sound warnings.

Now, however, products are available at reasonable cost that will allow advisers or individuals to screen their funds for style drift.

Ibbotson Associates in Chicago, for example, has two products that offer the investors the ability to screen funds for style based on their investment performance. They’re based on research by William Sharpe, a winner of the Nobel Memorial Prize in Economic Sciences.

The slimmed-down version is Fund Strategist, which costs $600 a year. The more powerful version is Encorr Attribution, which costs $7,000 a year and allows more-sophisticated screens not only of mutual funds but of separately managed portfolios.

Zephyr Associates in Zephyr Cove, Nev., offers for $15,000 per year a similar product but includes an asset-allocation package, the Morningstar mutual fund universe, a separate-account database and other tools. And more-complex and more-expensive products are out there.

Financial planners can now watch for style drift in client portfolios and help clients avoid the risk of being underdiversified. They can also assemble portfolios of mutual funds or separate accounts that are truly diversified by style.

That should be worth a lot more than those products cost.

Related Topics: Just Thinking