Since Graham & Dodd published their paper on Securities Analysis in 1934 and T Rowe Price rejoined with a piece in Barron’s on investing for growth later that decade, the two contrasting styles of growth and value have competed for the high ground in US investment. For a European pension plan to select a US manager without having a clear understanding of what each style means and how adopting a particular style will influence fund returns would be to fail to recognise a fundamental division in the market. Deciding whether and how to take advantage of style will have an impact not only on manager selection but also on the structure of the US portion of the fund.
To achieve a core US allocation, smaller pension plans may choose to go passive, or to adopt a low risk strategy that is style neutral. Gary Dowsett, investment consultant at Watson Wyatt points out that, for US managers, running a strategy with 2-3% tracking error is a very different proposition from the ‘enhanced indexation’ definition we have in Europe where the tracking error would be lower. Says Dowsett: “Managers running low risk money in the US tend to pursue a strategy which could be termed ‘low risk active quant’ whereby quantitative based strategies are applied to create a portfolio with a low tracking error and some active bets.” This approach is useful for funds that want to avoid the style issue, and achieve diversification through holding a larger number of stocks.
An example of a wholly mathematically-based large cap core approach is the INTECH product run by Janus subsidiary Enhanced Investment Technologies. INTECH run $4.1bn (E3.8bn) in large cap core mandates, exploiting the volatility of stock prices to generate an excess return over the benchmark in a highly risk-controlled manner. The process makes no reference to stock valuation or style. INTECH creates the ideal portfolio by rearranging stock weights in consideration of their volatility and estimated covariance so as to enhance return and reduce risk. By rebalancing stocks as they move away from and return to their optimal weights, the INTECH portfolio generates a return from volatility, which a wholly passive portfolio has suffered but not exploited. Since inception, the programme has achieved 1.65% pa excess return over the S&P 500 with tracking error of just over than 2%.
The concept of style investing developed in the 1930s when investors, reeling from the 1929 crash, groped for alternative philosophies to the previous hysteria of speculation. Graham & Dodd postulated that there was a floor to the value of a company that could be calculated with reference to the tangible assets it owned. Later that decade, once stock prices had recovered a little, T Rowe Price proposed that the best returns from equities would come from companies that were growing faster than the economy. The debate raged throughout the 1960s and 1970s and the notion that a manager was either ‘value’ or ‘growth’ became ingrained. The Russell 1000 growth and value indices were developed in 1984, providing a reference point against which to judge manager skill within the chosen discipline. As a result the vast majority of US pension funds in both their domestic and international mandates use style as a decision factor and positive benchmark. This trend has permeated into a few pension funds in the UK, the Netherlands and Scandinavia, but little elsewhere in Europe.
This does not mean that individual managers within one style will agree on what constitutes a value or growth stock, but that a value manager will tend to be measured against a value benchmark and a growth manager against a growth benchmark. According to Carl Beckley, head of research at FTSE International, which has developed global style indices, in the US, sector is often the distinguishing factor in whether a stock is considered value or growth, “a value manager might focus on sectors like utilities and never look at IT stocks,” comments Beckley. (See chart from FTSE of US Style Indices). Within Europe, delineation of stocks by sector is less obvious, with some stocks moving from value into growth and back irrespective of their industry group. And until recently, the country of domicile was a more important differentiating factor in Europe than style. The rapid advance of style investing and the easy division of stocks by sector within the US conveys an element of expediency given that US stocks account for some 50% of global equity market capitalisation.
According to Richard Haxe, marketing director at Alliance Bernstein in London, European investors are more likely to appoint a specialist US manager than UK plans, who tend to prefer global mandates. Haxe cites recent instances of internally managed funds in the Netherlands and Switzerland that have appointed an external manager for the US, retaining control of other markets in-house, considering the US the only developed market that requires local expertise. Maureen McFarland, business development director at Mackay Shields, reports more interest in US specialist mandates in the last year from European institutions, including the UK, with large cap mandates typically being divided by style. Comments McFarland, “A trend in the last six to 12 months has been for a large institution to have a core indexed portion and then add two high alpha managers, one large cap growth, the other large cap value. On the continent, sometimes the alpha generation is only sought within the small to mid cap sector.” William Babtie, marketing director at Franklin Templeton, indicates that larger UK plans will appoint as few as four managers in total, whereas European funds, preferring specialist mandates, might select seven or eight. US plans, being much more conscious of style differences in their own market, will appoint 10 managers or even more. A hindrance to UK plans appointing specialist US houses, according to Babtie, is that relatively few UK-based consultants research individual US managers operating on a regional basis.

Larger funds that can appoint two managers will tend to select both a value and a growth manager and set each one a target of 3-5% tracking error and 2-3% performance over the benchmark, which will be either a value or a growth index, depending on the manager’s style. Selecting a style benchmark essentially means that the manager is being measured against the universe of stocks that meet the style criteria, and so outperformance against that index can be seen as genuinely representing some measure of manager skill. Because the style and value indices of an individual supplier will include entirely different stocks, there is no inconsistency in benchmarking in this way. However, if value and growth managers are selected from different houses, there may be overlap because each individual investment house will have its own measures of what constitutes value and what constitutes growth.
If a fund were to go down the route of selecting a single active US manager with a strong style bias, then Dowsett recommends that pension plans select a complementary style to managers in another region, “for example a US growth manager would compensate for a value-biased European manager,” comments Dowsett of Watson Wyatt. According to Beckley, although not positively selecting managers on the basis of style, European funds appear to understand the effects of style and are making attempts to quantify risk and attribute performance to style factors. Industry experts are convinced that the concept will take hold in Europe as funds move towards DC and scheme members become more involved in portfolio selection. As Robert Schwob, chief executive of Style Research, a London consultancy, remarks, “US ERISA schemes are employee administered and style is an easy identifier for people who are not investment professionals to understand. Given that some 80-90% of excess return can be attributed to style, these labels are not simply useful for marketing. They provide greater choice and sufficient information about a manager for scheme members to make a meaningful investment decision.”
Within the large cap index arena, the Dow Jones Industrial Average and the S&P 500 indices are the best-known indices. However, the DJIA is not a suitable index for benchmarking, being price-weighted, which0 means that the index is simply the sum of the stock prices of each constituent. The S&P 500 index contains 87% NYSE stocks and 12.9% NASDAQ stocks. Some $1trn of money is indexed to the S&P 500.
All Russell indices are subsets of the Russell 3000 Index, which takes in 98% of US stocks. The top tier of stocks are contained within the Russell 1000 Index, which comprises 92% of the Russell 3000 by market cap and an average market cap of $11bn and median of $3.5bn. Its constituents are drawn 85.7% from the NYSE and 14.1% from NASDAQ.
The Russell Top 200 index contains the top 200 mega cap stocks, on average $41bn in size. The Russell 1000 index subdivides into the Russell 1000 Growth Index and the Russell 1000 Value Index, the former containing companies with high price/book value and higher forecasted growth and the latter lower price to book and growth rates. Growth and Value indices are available for the Top 200 and the 3000 series, but the 1000 Growth and 1000 Value indices are most representative of the large cap segment of the market.

Whether now is the right time to be devoting money to the market at all is a subject that exercises the mind of Ben Inker, global porfolio manager at GMO in Boston. “US stocks are the most expensive group of stocks in the world,” declares Inker, “since although they were more expensive at the top of the market, they have fallen less than other markets. Some suggest that their higher p/e ratios are because of higher growth rates, but the dividend payout on US stocks is less and their return on investment is no higher than stocks in other markets”. Inker also has concerns about the level of the US dollar, even though it has already weakened somewhat versus the euro and sterling. “It is not difficult to imagine circumstances which might lead to a dollar crisis,” warns Inker.
“The US is dependent on overseas savings, an inflow which could dry up. The devaluation in the exchange rate that would be required to bring the current account into balance would be enormous, of the order of 30-40%, a function of the small amount of imports and exports as a percentage of GDP.” Inker strongly recommends overseas investors hedge US dollar exposure to remove this risk, commenting, “given the disparity in interest rates, one is paid to hedge US dollars, and it is not clear what could make the dollar appreciate from this level”.
GMO considers that most consistent method of generating alpha is to combine value and momentum investing within a portfolio. It divides its large cap portfolio in 60:40 proportions, with 60% in stocks which meet value criteria and the remaining 40% invested in stocks with positive momentum, either in price or earnings terms. The methodology for ranking stocks for each portion is completely different and this diversification of approach is what smoothes returns.
Alliance Bernstein, which runs the largest portfolios of growth and value stocks in the US believes that value and growth are such totally separate disciplines that it runs the two businesses as distinct organisations, each with its own teams of analysts, portfolio managers and traders. The size of Alliance Bernstein US large cap investments, at $110bn in total, renders this delineation of responsibilities cost-effective. The Alliance Bernstein Global Style Blend is an active core equity portfolio that combines high conviction growth with deep value, rebalancing between them to maintain a 50:50 exposure. Haxe comments, “by combining these two lowly correlated products together, we are starting to occupy the core space. The blend services provide a good alternative for smaller funds that might not be able to afford two separate managers, to eliminate style bias.” Haxe sees a core mandate as not necessarily one with a low tracking error, but one that has no style bias, commenting that Alliance Bernstein would view a core mandate as having a tracking error of between 2% and 10%.
As an affiliate of New York Life, a top five insurance company in the US, Mackay Shields benefits from the backing of a large parent, while maintaining the feel of a boutique manager. Mackay Shields offers both a large cap value and a large cap growth product, and McFarland reveals that most interest has been in the value product, in reflection of recent markets. In total Mackay Shields manages $8.4bn in US large cap equities, of which $7bn is in growth mandates. A key differentiator, according to McFarland, is Mackay Shields’ strict adherence to style irrespective of market trends, and intense bottom-up research. Five separate portfolio managers are devoted to each product, with growth specialising in the sectors of technology, healthcare and media, and value in basic materials, industrials and defence. Growth managers screen on indicators such as EPS acceleration and relative stock price strength, whereas value managers focus on the lowest price/earnings and price to free cash flow. In both styles, quantitative screens are followed up with a qualitative assessment of the management and business case. As McFarland avers, Mackay Shields builds portfolios “one security at a time, only investing in stocks we like”. For the 10 years to September 2002, the MacKay Shields Large Cap Growth Composite achieved over 10% annualised net-of-fees return with lower volatility than the Russell 1000 Growth index which returned less than 7%. Over the same three-year period, the MacKay Shields Value Composite lost less than 5% annualised net-of-fees with slightly higher volatility than the Russell 1000 Value index, which lost over 6%, she says.
Standish Mellon attempt to take the best parts of both orthodoxies, by investing at the intersection of value and growth where stocks are reasonably priced but have good growth prospects. However, Edward Ladd, chairman at Standish Mellon, has concerns over the short-term direction of US markets, notwithstanding cheap long term valuations, because of the scale of the US current account deficit. Comments Ladd, “confidence in investments and in investment management has been damaged. But investors are often impatient and time horizons too short. On balance US stocks seem modestly attractive for those investors who have the patience and risk tolerance, although it will be a wild ride and excess returns over fixed income will be moderate.”
Janus’ largest wholly institutional product is its $1.69bn US large cap growth fund. The manager, Mark Pinto, focuses on companies with a market cap of above $10bn that demonstrate market dominance and predictable earnings. Some 60% of the fund is in stocks with a market cap above $35bn, the so-called mega cap band. The portfolio contains 48 holdings, which is towards the high end of the typical range of 35 to 50 holdings. The top 10 positions account for 38% of the value of the fund and the top 20, 64%. The fund retains about 17% in small to mid cap companies which the manager sees as having great potential to grow quickly into large cap companies. The core of the portfolio, some 60% of exposure, is in classic large cap growth companies, household names with strong franchises, such as General Electric, which are assumed to grow profits at around 15% pa. The mid cap growth element is fast growing but more volatile and may contain technology stocks. One holding that formerly resided in this portion of the fund was Dell Computer, now a large cap stock. The remainder of the fund is in stocks where a restructuring or change in the industry has rendered a stock a growth stock. An example of this was Heinz, which, after it had sold off underperforming divisions such as the pet foods, was able to improve margins. The portfolio has achieved a 13.8% annual return since inception in 1988, versus the Russell Growth Index performance of 10.18%, outperforming in 11 out of the last 15 years.
Pinto comments on the current market situation and how it affects the growth portion of the market, “whereas interest in the growth product was much higher three years ago, the environment for investing in growth is better because valuations and earnings expectations are now more conservative. Market uncertainty will impact growth and value stocks equally. An advantage of looking for growth is that even in an uncertain market it is possible to find companies whose earnings are growing.”

Whereas the earnings outlook is more positive now than in 1990, and interest rates 400 bps lower, US market strategists question whether the US market will rebound once the risk of war is removed (either by one side backing down, or by an eventual outbreak). UBS Warburg economists forecast that, on a speedy resolution of any conflict and fall in oil prices, economic activity should rebound in Q2 with GDP growth of 4.5%. This would lead to an improvement in profit margins. Recent cuts in earnings forecasts have been largely due to increasing pensions costs than deteriorating profits. Deutsche Bank analysts expect moderate expansion in the economy, but slow growth in capital spending, commenting that business spending is being held back by geopolitical risk. Morgan Stanley strategists note that the rate at which analysts are revising earnings forecasts down is decreasing, so setting a better tone for the market. The equity risk premium is above average, suggesting that while stocks are not necessarily cheap, US Treasuries are expensive. Short term volatility is higher than long term volatility, for fairly obvious reasons, but Morgan Stanley point out that volatility is one of the more predictable mean-reverting measures. In summary, Morgan Stanley suggest that the long term case for adding to risky assets is intact, but the short term remains captive to events in the Middle East.

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