Research

The Style Roulette And RAFI Strategy
By John West | July 26, 2010

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The first half of 2010 has been a roller coaster ride in global equity markets. The S&P 500 Index and MSCI All Country World Index posted gains of 5.4% and 3.2%, respectively, in the first quarter. But, as we’ve been suggesting for some months, the consequences of a global addiction to debt-financed consumption—sovereign, corporate, and household—started to take their toll in the second quarter, with the S&P 500 declining 11.4% and the MSCI All Country World falling 12.0% in U.S. dollar terms. Adding to this ride, value and growth styles have been flip-flopping in past years. If the current narrow value outperformance experienced in the first half of the year holds, 2010 will mark the fifth straight calendar year in which style leadership has shifted between growth and value.

This growth–value whipsaw is nothing new and begs several questions. Is there a better way to play the style game than splitting our equities evenly between growth and value? How reliable is the value premium? If we were able to magically win repeatedly in “style roulette,” what would be the rewards over a buy-and-hold index? Where does the Fundamental Index^® approach, with its inherent contra-trading against the market’s most extreme bets, fit within all of this? In this issue we explore some of these facets of equity style investing.

The Value Premium

The size and value premiums have been well documented in the literature, culminating in Fama and French’s highly regarded work in the early 1990s.¹ Table 1 provides empirical evidence on the size and reliability of the value premium relative to the broad market through May 2010. As Table 1 shows, excess returns for value investors ranged between 0.6% and 1.8% per annum, depending on the market. However, the variability in these results—that is, the tracking errors for value investing relative to the broad market—are substantial. Clearly, every so often a value approach will substantially underperform the capitalization-weighted broad market.

(For a larger view, please click on the image above.)

Of course, most U.S. investors experienced this first-hand during the tech bubble and collapse in the late 1990s and first part of the “Naughties.” It was a boom or bust period depending on which side of the style fence our portfolio sat (and significantly contributed to the large tracking error figures above). To prevent being blindsided again by another volatile value–growth cycle, U.S. investors attempted to diversify their largest bet—domestic equities—employing both growth and value approaches. This strategy, of course, reduces the equity portfolio’s variability to the broad cap-weighted market, but also gives up the value premium. So, what other choices are there for investors to win the style roulette game?

Winning the Style Roulette Game

Suppose we could perfectly time exposure to the winning equity style. If value wins in the year ahead, we’ll be in value and if growth wins, we’ll be in growth. To quantify a perfect run at the “style roulette wheel,” we built portfolios that were always on the winning side of the style bet each year.

Not surprisingly, the perfect foresight value–growth strategy leads to wonderful excess returns for all four strategies tested. Table 2 displays the premium such perfect timing portfolios would have produced. In U.S. large company equities, placing 100% of our funds in the winning style would have produced an annualized return of 16.5% for the 1979–2009 period—500 bps ahead of the cap-weighted broad market! Substantial excess returns also were available in global and non-U.S. strategies, measured in somewhat shorter time frames. These are impressive figures but, like a run of 20 straight “reds” at Monte Carlo, unattainable to us mere mortals.