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.

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