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20120605_DGFI_White-Paper_Investment_Styles.pdf
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ABSTRACT
In recent years, economic performance has been anaemic in market economies worldwide – a trend that is likely to continue over the next two years. The Organisation for Economic Cooperation and Development (OECD) forecasts tepid growth in 2012, from 0.5% in the United Kingdom and 0.2% in the Eurozone to 2.4% in the United States. Moreover, unemployment is expected to remain high and interest rates low. In such recessionary markets, what kind of mutual funds are likely to prove good investments?
Morningstar and other mutual fund rating sites typically categorise equity mutual funds in two major dimensions: market-to-book ratio (growth vs. value) and size (small-cap vs. large-cap). Research shows that these two dimensions proxy for stock risk characteristics that do not seem to be captured by beta, and academics agree that, over the long term, value stocks and small-cap stocks earn significantly higher returns than are predicted by their risk profiles. These two anomalies are the basis for other calendar-type anomalies. For instance, the “small firm effect” has been shown to be related to the “January effect” – i.e., small firms earn significantly higher returns in January. Hence, it might be assumed that a straightforward strategy for long-horizon investors would be to buy small-cap and value funds and hold on to them over the long term.
In this paper, we investigate how stable these two anomalies are over different stages of the business cycle, using a sample of U.S. equity mutual funds over the period 1993-2010. A stable relationship would show that investors need not pay attention to the business cycle when deciding which types of funds to invest in – as an unconditional investment in small-cap or value funds will then always earn significantly higher risk-adjusted returns than investing in large-cap or growth funds. By contrast, a time-varying relationship would show that investors might be better off strategically shifting from growth to value or small-cap to large-cap funds during expansions or contractions.
We find that, consistent with conventional wisdom, value funds typically do earn higher returns than growth funds over the course of the business cycle, and that small-cap funds earn higher returns than large-cap funds. However, this pattern changes during contractions, when large-cap and growth funds earn significantly less negative returns than value funds. Since expansions lasted longer than contractions over the observation period, we observe that, if one were to favour a passive holding strategy, a portfolio consisting only of small-cap and value funds would deliver higher returns over the long term.
To specifically hedge against contraction risk, however, investors need portfolios that deliver counter-cyclical returns. We examine several such portfolios and analyse their potential to deliver higher returns than portfolios relying on a passive index-fund trading strategy. For example, a portfolio overweight in growth funds and underweight in value funds yields counter-cyclical returns. Alternatively, investors can also go overweight on growth funds to hedge market downturns and shift strategically to value funds during expansions. However the effectiveness of shifting strategies is dependent on the speed of execution. Ideally, to generate higher returns than a passive benchmark, a strategy shift needs to be executed within one quarter of the market contraction’s occurrence. A lag time greater than one quarter significantly diminishes the value of switching strategies.
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