Think outside the style box

You don’t need a portfolio makeover to take advantage of smart beta. Sara explains how to refresh the Morningstar fund style box.

According to the Fall 2017 Pantone Fashion Color report for New York, this season is all about Grenadine red and tawny Autumn Maple. I like a pop of color, but I’m still keeping my traditional black and navy staples. If you are a traditional style box investor, can smart beta exchange traded funds (ETFs) refresh the style in your portfolio?

The investment universe was traditionally carved up between growth and value, and large and small securities. Several decades ago, Morningstar introduced the now-ubiquitous nine-box matrix known as the style box, providing a framework to evaluate funds against peers with similar investment styles.

Today, technological improvements and better access to data have democratized style investing beyond simple value and size screens to target historically rewarded style factors in a cost effective way.

The evolution of style

Style box investing began with actively managed style exposure funds and moved on to style-tilted index funds weighted by market cap. The industry is now turning to factor exposures that more directly screen for attributes traditionally sought by active funds—cheap, trending, high quality, more stable and smaller names—weighted by the strength of these metrics.

Style factor investing with ETFs takes the concepts introduced with the nine-box grid and modernizes them. Just as investors combined blend, growth and value funds in a portfolio, they now have the ability to combine momentum, quality and value factor exposures—more directly targeting these broad, historically persistent drivers of return.

Investors can consider a few ways to update their style:

1. Swap growth for momentum

Traditional growth investing seeks capital appreciation by investing in companies that have high expected earnings and may steadily increase in value. Similarly, the momentum factor targets stocks that are trending up in price. In other words, the term “momentum” is a new way to describe what many growth managers have historically tried to deliver.

Momentum factor investing tends to be highly cyclical and focused on a concentrated portfolio of stocks displaying stronger price appreciation than their peers. This exposure directly maps to the investment characteristic that has driven returns for active growth managers in the past.

2. Upgrade blend to quality

Blend investments have traditionally provided broad exposure that’s neither strongly growth nor strongly value. Many active managers in the blend section of the style box enhance their performance over the long run by looking for securities that have strong earnings and a reasonable price.

In the same way, quality investing focuses on buying bellwether firms with strong balance sheets and stable earnings. Investors in this style have typically been rewarded in the later stages of the economic cycle, including downturns, as companies with resilient business models and attractive return on equity may offer defensive protection in the portfolio.

Quality factor indexes can potentially provide a more appropriate benchmark to help investors evaluate blend managers. These indexes more closely align with the active investment process than broad market cap-weighted indexes.

3. Deepen your value

Value investing draws on the idea of buying companies that are priced inexpensively relative to their fundamentals. Value investors invest in companies with pro-cyclical business models that tend to be rewarded in market booms and over longer holding periods.

Value factor investing tends to have more concentrated style exposure and stronger factor weighting than the average active value fund or market cap-weighted value index, residing on the far left-hand side of that Morningstar style box. ETFs with this focused exposure to value can be a low-cost way to target inexpensive names, which have historically fared well when interest rates are rising.

Smart beta ETFs

Smart beta ETFs take advantage of time-tested investment ideas and today’s advances in data and technology, providing a lower-cost alternative to mutual funds. But that doesn’t mean you have to remake your portfolio: Smart beta ETFs can refresh the traditional style box framework. Investors may consider complementing or replacing existing active strategies to help reduce average costs or seek to improve overall performance.

Style-savvy smart beta strategies to build a balanced U.S. portfolio include iShares Edge MSCI USA Momentum Factor ETF (MTUM), iShares Edge MSCI USA Quality Factor ETF (QUAL) and iShares Edge MSCI USA Value Factor ETF (VLUE).

Sara Shores is the Head of Strategy for BlackRock’s Factor-Based Investments and a regular contributor to The Blog.

Carefully consider the Funds’ investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds’ prospectuses or, if available, the summary prospectuses which may be obtained by visiting www.iShares.com or www.blackrock.com. Read the prospectus carefully before investing.

Investing involves risk, including possible loss of principal.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date indicated and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any of these views will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.

This post contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.

There can be no assurance that performance will be enhanced or risk will be reduced for funds that seek to provide exposure to certain quantitative investment characteristics (“factors”). Exposure to such investment factors may detract from performance in some market environments, perhaps for extended periods. In such circumstances, a fund may seek to maintain exposure to the targeted investment factors and not adjust to target different factors, which could result in losses. The iShares Minimum Volatility ETFs may experience more than minimum volatility as there is no guarantee that the underlying index’s strategy of seeking to lower volatility will be successful.

Diversification and asset allocation may not protect against market risk or loss of principal. Buying and selling shares of ETFs will result in brokerage commissions.

The iShares Funds are distributed by BlackRock Investments, LLC (together with its affiliates, “BlackRock”).

The iShares Funds are not sponsored, endorsed, issued, sold or promoted by MSCI Inc., nor does this company make any representation regarding the advisability of investing in the Funds. BlackRock is not affiliated with MSCI Inc.

©2017 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

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