Style Diversification In International Markets
By: Lane Prenevost
Over the last decade, the benefits of exploiting value and growth styles have been deeply entrenched in portfolios invested within North America. However, style diversification did not receive the same amount of attention in international equity allocations. International equities were generally categorized as a broad separate asset class and rarely further subdivided by management style.
More recently, a change in this practice has emerged as more plan sponsors are recognizing the importance of refining this approach. This trend is due, in part, to the performance dispersion between value and growth returns globally. When investing internationally, it is evident that a key factor that differentiates returns is whether a portfolio is oriented towards value or growth.
This article will attempt to discuss the reasons why sponsors have not traditionally recognized the importance of style globally. As well, rather then biasing a portfolio towards value or growth, a style-balanced approach within an international allocation is the most effective method to manage risk-adjusted performance. This is despite evidence that value has dominated growth over an extended horizon. Finally, value and growth performance varies significantly between countries. An internationally diversified portfolio is also an effective strategy to manage style risk.
Style Around The World
Style-based investing in the United States developed mainly in the 1970s. Style was identified as a way of explaining return variability by categorizing equities with similar characteristics. It was observed that companies with rapidly growing earnings commanded higher valuations and experienced different performance cycles than stocks that were underpriced relative to the market. It wasn’t until the last decade that style investing was widely used in investment policies in North America.
During this time, value and growth management styles have become more clearly defined. Value managers tend to look for companies that are priced inexpensively based on common ratio analyses such as price to book value, price to earnings, and price to cash flow. Growth managers generally focus on operational, rather than valuation, ratios. For example, growth managers look for companies with above average return on equity, return on capital, and growth in earnings. These two approaches focus on bottom-up business analysis rather than the use of a macro-economic framework in constructing portfolios.
Sponsors did not recognize the relevance for international mandates even though strategies involving value and growth characteristics were widely accepted in North America as effective in adding value. This was the case even with academic and market practitioner research advocating further segmentation. Research from Capaul, Rowley and Sharpe (1993) on international markets categorized equities using price to book ratios and determined that, between 1981 and 1992, low price to book (value) stocks in various countries outperformed high price to book (growth) stocks. Fama and French (1998) expanded an earlier paper written on the U.S. experience to an international case study and concluded that low price to book stocks experienced superior returns relative to high price to book stocks over an extended period (1975 to 1995). The authors attributed this result to the existence of a value premium for the relative distress associated with firms with low price to book ratios. Further studies on international style investing from Lakonishok, Shleifer, and Vishny (1994) revealed that much of the superior performance of value stocks was due to behavioral reasons such as overconfidence, emphasis on past results, and agency costs such as overpaying for glamour stocks or avoiding troubled companies.
These studies were consistent in demonstrating two key points:
- there was a distinction between value and growth style in international markets
- there appeared to be an excess return of value in international markets
The outperformance of value versus growth is evident when observing the return series of the Morgan Stanley Capital International Inc. Europe Australasia and Far East (MSCI EAFE) Value index relative to the MSCI EAFE Growth index since inception (see Chart 1). The spread between value and growth returns is determined by subtracting the return of the growth index from the value index. The result is a return advantage (if positive) or disadvantage (if negative) from holding value rather than growth stocks.
Attitudes Toward Style In International Equities
Although previous studies supported the awareness of style within international mandates, there were some key reasons why sponsors did not consider value and growth in portfolio allocations. These include:
- During the 1990s, the Japanese market experienced weaker performance relative to the rest of the world. Portfolio managers were able to outperform in international markets by under weighting Japan. Consequently, there didn’t appear to be a compelling reason for sponsors to consider style diversification since regional weighting was a prime factor in enhancing returns.
- Smaller equity markets tend to be more highly concentrated. There are markets where one or two stocks make up more than 50 per cent of the country benchmark such as in Finland and Norway. When a market is dominated by a few securities, it is difficult for a portfolio manager to consider diversification by style.
- There was a lack of international style indices. International style benchmarks are essential to assess manager style and subsequent performance, as well as provide data for asset allocation research.
- Investors were more accustomed to categorizing international holdings according to regions or various stages of economic development, rather than style.
Along with the efforts of consultants to encourage revisions to portfolio strategy, many developments over the past few years are contributing towards the recognition of style internationally. They include:
- The movement towards shareholder-oriented cultures similar to North America. More transparent and frequent disclosure from companies globally allows for better analysis of fundamentals that are used to determine value and growth characteristics.
- The valuation of stocks on a regional and global basis, with fewer intracountry comparisons. Analysts and investors have recently begun to compare securities by sectors globally rather than isolating analyses to particular countries.
- The declining weight of Japan in international benchmarks. Japan does not have the importance that it had back in the early 1990s. Therefore, portfolio managers are focusing more on equity fundamentals to generate value.
- The introduction of style indices by index providers such as MSCI, Citigroup, and FTSE. There are now several benchmarks available to measure relative performance.
If style management can add value to a diversified portfolio domestically, then it should also do so for an international portfolio. Increased globalization, as well as investor attitudes toward international diversification, should influence this trend towards an integrated framework in portfolio management.
Now that more sponsors are moving towards the use of style mandates in EAFE markets, what strategies should be employed? Should value be used instead of a blend or style balanced approach?
Much of the historical evidence points towards the long-term dominance of value investing globally. Over the past 30 years, value stocks produced superior long-term performance over growth stocks in the EAFE markets. As mentioned earlier, some studies explain this through the existence of a value premium, while others explain that the outperformance is due to behavioral reasons. However, when observing the performance differential between value and growth on a shorter-term basis (oneyear rolling differences in returns), there is a distinct rotation in performance between both styles (see Chart 2). Some investors are concerned with risk management issues such as implementing a mandate with a risk budget. In addition, many investors face shorter-term assessments of performance. With consideration for these issues, a stylebalanced approach is more appropriate. Although value has outperformed over the long run, it has experienced periods of underperformance in times of increased market volatility. The risk of underperformance for a portfolio exclusively invested in value would be significant if the market becomes biased to momentum (or growth) stocks during such a time.
Another issue is the singular use of measures such as price to book ratios to assess whether a stock is value or growth. MSCI is a major index provider whose indices are used extensively as a benchmark for international managers. They formerly segmented value and growth in style indices using only the price to book ratio. As a result, the growth index reflected expensive stocks and included those with low realized growth. These expensive stocks that also had low growth significantly underperformed the market over various periods. However, skilled growth managers should be able to identify high growth opportunities more effectively and avoid expensive stocks with disappointing growth. Of note, in an effort to increase the robustness of their style indices, MSCI began implementing a multi-factor approach to identifying value and growth stocks in 2003.
Style diversification can be achieved through investing across countries internationally as well. Value versus growth performance fluctuates at different times and magnitudes throughout countries around the world. Since individual countries tend to experience different cycles of economic growth, corporate profits, inflation and interest rates, value and growth stock performance differ between regions globally. The differences in industry composition among each of the countries can also affect which style performs well at a particular time. For example, Japanese companies are more cyclical and their growth is moreover related to their position in the economic cycle relative to other countries. When picking a manager or managers, it is important to recognize that styles go in and out of favor. Returns of value and growth can vary significantly globally from month to month or year to year. As value or growth cycles are difficult to predict accurately, exposure to the broad international markets using a style balanced approach is an effective way to diversify both style and country risk. This is evident through the low crosscountry correlations of the differences between value and growth returns. To illustrate, the value versus growth cycle was examined in two primary EAFE regions: Europe and the Pacific. The 10-year historical correlation of the value-growth differential was 0.27 (see Chart 3).
What would be the effect on style diversification of combining a domestic portfolio with an international portfolio? The international value-growth cycle also varies significantly from that in Canada. As evident from a cumulative performance graph of the value minus growth difference over the past 30 years (see Chart 4), Canada has experienced significant style volatility compared with international markets. In particular, the TMT bubble in the late 1990s contributed to the strong performance of growth stocks domestically. Furthermore, the low correlation of the value-growth cycles in Canada relative to international markets (see Chart 3) demonstrates the effectiveness of style diversification when including international equities in a Canadian portfolio.
It is apparent that international equity style investing provides diversification benefits. The volatility of style cycles, as well as the difficulty in predicting a winning style in a particular market, point to the importance of adopting a globally balanced approach. An important goal in determining manager structure is to achieve a reduction in relative risk (tracking error), while generating excess returns. Combinations of international style managers can achieve this result and improve the risk-adjusted return of a portfolio.
Lane Prenevost is director, portfolio strategy, at TD Mutual Funds.
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