What is an All-Cap Core Approach
An All-Cap Core investment approach expands equity opportunities to include all levels of market capitalization and the range of style classifications. Rather than a constrained focus on a limited area of the investment universe, an All-Cap Core approach allows for flexibility to pursue the most attractive opportunities, no matter where they fall within the predetermined style spectrum.
The institutional investment community often uses specific style boxes as helpful tools to compare manager performance and build diversified portfolios, yet an All-Cap and/or Core (also referred to as Blend) outlook can offer a valuable investment philosophy despite not fitting neatly into a style or capitalization box. Within this article, we present four main potential issues with narrow style classifications:
- Style based managers are often forced to track benchmarks.
- Style definitions are neither clear nor consistent.
- Style classifications for individual stocks and sectors can shift over time, which would cause buy and sell decisions to be based on shifts in style benchmarks rather than fundamental factors.
- Styles move in and out of favor, often with long and varied performance cycles.
This discussion highlights the potential weakness in strict style classifications and outlines the benefits of an actively managed All-Cap Core approach, where investments are based on company and industry dynamics rather than style, market cap, or regional definitions.
Limits of Style-Based Investing
I. Tracking the Benchmark
The presence of distinct investment styles has existed for decades, but the evolution into Value and Growth style boxes is more recent. Standard & Poor's (S&P) formed large capitalization style indices in 1992, the same year that Morningstar created style boxes. Morningstar did not start categorizing managers according to style until 1995. While the emergence of explicit style classifications has become useful for investors, trying to follow a certain style can create issues, especially if tracking an index ends up becoming the driving force behind investment decisions. Popular concepts such as style drift and tracking error, which measures the divergence between the performance of a portfolio and a benchmark, can pressure managers to minimize or control any deviations relative to an index, thus placing an artificial importance on specific style and cap classifications.
Exclusively relying on index guidelines to determine investments can be restricting. For instance, a manager may identify a compelling opportunity that is considered Value at the time of purchase, but transitions into a Growth investment during different market conditions. The rigid application of style boxes may imply that a Value fund should not continue to hold this now Growth stock, even if it presents the potential for strong future returns.
Also, managers are often categorized based on the stocks in their portfolios at a given time. This method relies on a single snapshot of a manager's portfolio and does not take into account the timing of equity purchases and sales, or whether a stock's style has shifted. Labeling managers based on a static look at their portfolios may not provide the most thorough insight into how a manager adds value across various market environments. Simply put, managing a portfolio to match a specific style classification may not always capture the strongest long-term opportunities.
II. Varying Definitions
While relying on style boxes has become common practice, there is no universal acceptance for a clear definition of what constitutes Value or Growth. Even S&P acknowledges there is no consistency of style definitions among leading style indices or at the stock level. As detailed in the following table, S&P focuses on six factors to evaluate Growth and Value ratings.
These measures are used to calculate a Growth Score and a Value Score, which are ranked to determine the stock's placement in the indices. (A higher Growth Score places a security in the Growth Index, and a higher Value Score places a security in the Value Index.)
Other providers of Growth and Value classifications use differing methodologies. For example, Morningstar treats Value and Growth separately in its classification strategy. According to the company's descriptions, a stock's Value relates to its price compared to per-share earnings, book value, revenues, cash flow, and dividends. The Growth rating excludes price and reflects the growth rates of fundamentals such as earnings and cash flow. If not clearly Growth or Value, Morningstar will categorize a stock as Core. The Russell U.S. indices use price-to-book ratios and growth forecasts for classifications. Higher price-to-book ratios and forecasted growth rates are assigned to the Growth Index, while equities with lower price-to-book ratios and forecasted growth rates are included in the Value Index.
To add to the confusion, Russell can designate a certain percentage of a stock's weight to its Growth Index and the remaining percentage to the Value Index, thus dividing the stock's classification. As these varying definitions imply, identifying a stock or a manager as Value or Growth oriented can be ambiguous, especially without a careful review and understanding of the criteria for that label. As a result, adhering to diverging yet particular definitions of Value and Growth can be limiting for managers seeking to add value in all market environments.
III. Shifting Classifications
In addition to inconsistent style definitions, the underlying sectors and securities that comprise a certain style index can shift over time. Using the Russell 1000® style indices as an example helps demonstrate the swings that can occur. The tables below show sector weightings for the Russell 1000® Growth and Value Indices from December 2006 through October 2009 and reveal major changes in sector allocations.
As an example, the Financial Services sector accounted for nearly 40% of the Russell 1000® Value Index prior to the credit crisis in 2006, but fell to less than 25% of the index following the rout in Financial Services stocks that took place during 2008. A Value manager might be expected to make similar shifts in sector allocations based on this dramatic change in the index, or risk deviating too far from expectations. While an All-Cap Core approach can also experience changes in sector allocations as market conditions shift, these changes are generally based on fundamentals, not short-term, uncontrolled changes within an index.
The Energy sector from 2006 to 2009 is particularly illustrative of how allocations based on index classifications may differ from a fundamentals-based All-Cap Core investment approach.
Oil prices started rising in 2007 and peaked at extremely high levels in 2008. Based on Russell's Growth and Value classifications, Growth managers would have been expected to increase their allocation to Energy and maintain that increase through 2008. In other words, Growth managers would have been buying Energy stocks as their prices were rising and maintaining exposure when prices started to fall. Only after oil prices dropped substantially at the end of 2008 and into 2009 would Growth managers have been expected to roughly cut their Energy holdings in half (i.e., when the allocation to Energy stocks within the Russell 1000® Growth Index fell dramatically). These managers would have effectively been buying high and selling low.
In this case, following the style indices would not have produced favorable returns, but using an active All-Cap Core approach based on company and industry analysis may have led to a better outcome. We started trimming Energy investments in 2007 and into 2008 to take profits from higher prices, and gradually began buying Energy companies in 2009 at much lower prices, the opposite timing of the allocation shift in the Russell 1000® Growth Index.
Along with sector shifts, individual stocks can also move between set style classifications over time. Analyzing the Growth Scores that Russell 1000® assigns to its index constituents - a score of 1 indicating a pure Growth stock with total allocation to the Growth Index - illustrates notable style changes at the company level as well. Out of the 789 stocks that appeared in the Russell 1000® Index at all four dates in the previous charts, 102 stocks (over 12%) experienced a complete shift in pure style classification from 2006 to 2009, meaning they jumped from pure Growth to pure Value or vice versa. Almost 300 stocks (about 38%) had a difference in scores of 0.5 or more, signifying a substantial migration in style classification.
The table below shows the median score range for stocks in each sector; the higher numbers represent sectors with the largest style changes. Sectors such as Energy and Materials and Processing had the widest shifts, implying a potential degree of cyclicality to the Growth and Value classification process.
The previous discussion concentrates on the complexity of defining, calculating, and adhering to particular styles, yet "All-Cap" is an important aspect of the All-Cap Core investment approach. Market capitalization groupings are generally more straightforward to determine. A stock is considered Small-, Mid-, or Large-Cap based on its size. As the definitions imply, a company can still move between capitalization levels if it grows or shrinks, and certain market caps can present unique opportunities. A Small- or Mid-Cap company may capture one area of an industry, while a multinational Large-Cap stock may be exposed to different growth prospects. Therefore, an All-Cap Core investment approach has a significant advantage in its flexibility to assess every possibility across market capitalizations and style classifications in order to build a strong, diversified portfolio for distinct conditions, without being limited by short-term classification shifts.
An All-Cap Core approach does not pick stocks based on where they fall within style indices, which as referenced previously, may not be stable or consistent. Instead, an actively managed All-Cap Core process can apply disciplined stock selection strategies to a broad universe, allowing the manager to adjust to evolving conditions to pursue the best long-term opportunities in any style.
IV. Performance Cycles
Having the ability to analyze and invest in all types of stocks means a manager can capitalize on environments that are conducive for particular equity styles and market caps. Style classifications and market capitalizations have cycles of performance that can last for varying periods of time, which means not being able to invest in some of these areas can impair results.
The volatility of style returns is also pictured in the chart below, which portrays why the ability to seek opportunities in all investment styles is essential to achieving absolute returns over full market cycles. Ultimately, every cycle is different because market conditions are constantly changing, which offers a strong argument for a disciplined yet opportunistic investment approach across a wide universe.
It's not only style classifications that have swings in performance. Returns for small, mid, and large capitalizations also exhibit periods of outperformance and underperformance. The graph below depicts the frequency, length, and performance of Large-Cap and Small-Cap cycles, and as with style classifications, there is broad variation. The Small-Cap cycle from 1999 to early 2007 marked the longest and largest period of Small-Cap outperformance since the earliest available Russell data dating back to 1979.
Similar to cyclical style returns, the graph below illustrates the lack of consistency in performance across different market caps. Once again, the flexibility to find attractive investments across all equity sizes and styles is important to providing favorable returns in all environments.
Finally, some All-Cap Core managers expand their universe further to take advantage of opportunities on a global scale. The United States represents roughly half of the MSCI ACWI Index (NASDAQ:ACWI), so a global perspective provides considerably more possibilities, especially when some countries may offer more attractive prospects than others at times. The graph below shows the volatility in domestic versus foreign performance, which suggests that using prudent stock selection strategies across a large international spectrum could allow a manager to excel in all types of international performance periods.
All-Cap Core: A Strategy for Investing in the Real World
An All-Cap Core approach does not divide the investment universe into contrived styles and sizes, but rather emphasizes fundamentals as well as company and industry dynamics to drive investment decisions. By monitoring conditions across an entire industry, similar to how an industry expert would view the competitive landscape, an All-Cap Core manager should be able to understand key investment factors that transcend style classifications, market capitalizations, and even regional definitions. This focus on bottom-up specifics can identify opportunities that may be missed if a pre-defined style screen were applied.
In general, an All-Cap Core approach looks at the world as an active participant would. Company executives and industry leaders do not usually think in terms of Growth or Value businesses, they look at the world more broadly to determine developing trends. So why should an investor allocate money any differently? It would probably be difficult to find a Value manager who did not want any growth represented in their investments, and it would likely be hard to find a Growth manager that didn't believe their stocks had any value characteristics.
Ultimately, because an All-Cap Core approach is not limited to a particular style or market cap, it has the flexibility to pursue opportunities that may perform well in different environments, an important element of achieving positive returns over full market cycles.
An All-Cap Core approach may not fit precisely into popular style boxes, but it delivers important diversification through a beneficial investment outlook and a focus on investment fundamentals. Instead of following strict style indices that may have vague definitions and shifting underlying components, an All-Cap Core manager can concentrate on long-term investments and seek out return potential, wherever it may be. Furthermore, distinct equity styles and capitalizations can experience significant and varying performance cycles that make the flexibility of a wide investment universe even more important. In summary, an All-Cap Core approach provides an opportunistic investment philosophy that seeks to add value in all environments.
Sources: MDT Advisers, Standard & Poor’s, Morningstar, Russell Investments, MSCI, Bloomberg.
Disclaimer: All investments contain risk and may lose value. This material contains the opinions of Manning & Napier Advisors, LLC, which are subject to change based on evolving market and economic conditions. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy, or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.