Distinct investment styles prove more difficult down under

Activemanagers use different investment styles with the aim of outperforming the market. In the US, ‘value’ and ‘growth’ are two of the key styles used by fund managers when investing in the share market.

However, when investing in Australia, these imported concepts have limited applicability.

Australian market characteristics make it difficult to manage an investment portfolio with a pure value or growth orientation. Compared to the US, the Australian share market is much smaller and it is harder to allocate stocks into value and growth sectors.

Indices are statistical indicators that are used to assess the performance of the market as a whole, or segments of the market. Indices often serve as a benchmark against which the performance of a fund can be measured.

Due to the lack of depth in the Australian market, the make-up of our indices differs to those in the US as the graph below shows.

The Russell 1000 Index reflects the 1000 largest companies traded in the US.

The graph shows that 70 per cent of companies in the Russell 1000 Index are assigned to either the value index (the companies with the lowest price-per-book value ratio) or the growth index (the companies with the highest expected growth of earnings).

So, a value manager will usually buy stocks from approximately 350 companies that a growth manager will not normally consider, because these stocks do not meet the growth selection criteria.

Similarly, a growth manager has an approximately equal number of stocks they would buy from. A value manager would not consider these stocks due to the screening process, which eliminates the stocks they consider overvalued.

The other 300 companies are reflected in both indices. A portion of the return is credited to the value index and the rest to the growth index because they exhibit moderate value and growth characteristics as described above.

By comparison, the number of stocks in Australia’s broadest index is less than the large capitalisation Russell 1000 Value Index. In fact, the direct US comparison to the S&P/ASX 300 would be the Russell 3000, which has 10 times the number of stocks.

It is no wonder the Americans split the index into sub-sectors! It would be virtually impossible for any one manager to analyse that many companies in any depth.

One of the key Australian share market indices, the S&P/ASX 300 Accumulation Index, is not even sub-divided.

The index providers that do separate the Australian market use a smaller portion of the 300.

Salomon Smith Barney, for example, uses approximately 179 companies in their broad index, then splits these between value and growth. Because of the narrow market, most of the companies appear in both indices (see graph).

As at May 2002, there were only 34 companies that were exclusively in the Australian Growth Index and 38 companies in the Value Index. This is significantly different to the US situation where most stocks are exclusive to either the value or growth index.

The difference in index construction between Australia and the US does not fully explain why managers in Australia lack strong value or growth investment style characteristics. However, the way the indices are ultimately used does.

In practice, a pure style manager only buys stocks that fit into the style category in which they manage.

For example, in the US a pure growth manager would only buy those stocks that pass the ‘high expected growth in earnings’ test of the Growth Index.

Similarly, a pure value manager would only buy those stocks that have a low price relative to earnings, book value, and so on.

In Australia it is very difficult to achieve this goal. With only a small number of companies fitting into either the Growth or Value Index, managers find themselves selecting most of their holdings from the ‘middle’ category (where stocks exhibit characteristics of both value and growth).

The result is that value and growth portfolios tend to hold the same stocks. In fact, it is not uncommon when comparing value and growth portfolios to find that most holdings are common between the two.

This means in spite of their different styles, their performance could be very similar. In the US, a typical manager that invests in growth stocks may hold just one stock in common with a value manager.

Reinforcing the idea that managers in Australia differ very little in investment style, the success or failure of their strategies is measured against the S&P/ASX300 rather than against a style index.

Australian managers tend to be judged against the broad market, which forces them to attempt to outperform in all scenarios. Therefore, they construct portfolios that are often slanted towards the middle of the market.

With the broad market as the ultimate benchmark, funds tend to emulate the middle and add value in ways other than style.

In the US, a growth manager will be measured against the Growth Index. As a result, they manage their portfolio risk against the Growth Index rather than the broad index. The outcome is that their portfolio construction looks dramatically different from one designed to outperform in all market climates.

While we would not suggest that managers in Australia do not have a style bias in the way they select stocks, the breadth of the market limits their ability to construct portfolios that will perform in dramatically different ways to another manager with a different bias.

In simple terms, most managers have a style bias, but in Australia the effects of this bias are not very significant.

The effect of the commonality between growth and value managers in Australia is exacerbated by the fact that all managers are measured against the broad market.

The focus on identifying style in this environment has over-emphasised its importance.

With portfolios managed so close to the middle, good stock selection can sometimes outweigh the impact of style on fund performance.

Diversification between funds is still desirable and style bias is a reasonable methodology to use in combining portfolios.

However, when selecting a fund manager, your focus should be on their stock selection abilities, as well as their style.

Rick Villars is HSBC Asset Management’s head of retail, responsible forretail and private client units inAustralia.