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Meanwhile, investors with long- or short-term views on the economy will likely be frustrated with the bluntness of the style index choice, pure or otherwise. Sectors provide investors with far greater precision to express top-down macro views. Moreover, viewing the market by sectors aligns with how investors—and everyone else—interact with the world intuitively on a day-to-day basis. Investors can name top tech firms by looking at the logo on their smartphone, and they identify energy companies and consumer stocks in a similar manner. Viewing the market by growth and value is far more abstract. "Intuitive" doesn't mean right and "abstract" doesn't mean wrong, but a more transparent framework for allocation should lead to better decisions. If investors understand the bets they're making, they should have a better sense of when to stay the course and when to try a different tack.
Investors who come to index investing from a risk perspective rather than an economic one might reach for style more on reputation than reality. Perhaps they'd think a growth fund suits a younger investor with a long time horizon, while a value index works better for a pensioner's equity exposure. Our data show, however, that both value and growth have been more volatile than the market in each of the five time periods we looked at (see Figure 11).
Yet as mentioned above, certain sectors have shown consistently low volatility (consumer staples, health care, utilities) just as other sectors have shown consistently higher volatility (financials, energy, materials). This suggests that sector exposure may be a more effective way for investors to find the desired spot on the risk/reward spectrum (see Figures 12a and 12b). The S&P 500 Low Volatility Index behind the wildly popular PowerShares SPLV ETF shows strong biases to these low-volatility sectors, while exhibiting mixed style messages (growthlike high P/E and P/B mixed with a valuelike high-dividend yield).
Can style indexes be viewed as aggregates of sector exposure? Exhaustive style pairs hold the entire market between them, and so must hold all the sector stocks. Style indexes certainly show bias toward certain sectors, as we've highlighted. Yet the aggregation of sectors into style indexes is far from neat. Industrials and basic materials, for example, are split about equally between the pure growth and value indexes. Pure style indexes leave out about one-third of the market, which undercuts their ability to reflect groups of sectors, even if they were perfectly defined. In the end, style indexes are engineered to select and weight stocks by fundamental and momentum factors, not by industry exposure. A value fund captures financial stocks by their low P/Bs (from high book values) but also snares energy stocks with low P/Es (from high earnings). However, some firms from these two sectors exhibit different ratios that park them in the pure growth index (which has roughly 10 percent combined financials and energy).
Style funds work with discrete buckets sizes. Exhaustive style pairs split the market 50/50. Style-pure indexes split the market in thirds. A stock migrates over boundaries because its attributes change (a higher P/B ratio forces it out of value and into core perhaps) or because the attributes of other stocks get stronger and force it out of the bucket. In this sense, the indexes remain true to their style mandate while the names inside it change. A pure growth fund will always represent the "growthiest" one-third of the market, even if the nature of the constituents changes (e.g., less tech, more health care).
A sector fund stays true to its mandate as well, but its constituents tend to stay put. A tech firm, for example, stays in a tech index as it journeys from brash startup to cash-cow dividend payer. In contrast, the same firm might migrate out of a growth index and into a core index (or have its weight partly assigned to value). The tech fund's footprint in the market—the relative size of each sector's bucket, in other words—can vary dramatically over the long run, as its aggregate market value of equity ebbs and flows.
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