Do you have friends who invest in stocks or mutual funds? If you do, have you ever asked them the reason behind those purchases? More often than not, you will hear answers like, “this stock is cheap compared to its valuation” or “this stock has a lot of growth potential” or even “this fund is managed by an outstanding fund manager.” These answers reveal the investment style of your friends. This article will introduce some main investment styles to you.
What is investment style?
Investment style refers to the approach that investors, including fund managers, take in selecting individual investments and assembling portfolios following a certain investment philosophy.
Investment styles of fund managers are usually determined by the following factors:
a) Risk-return objectives set for the fund
b) Profile of investors (age, income, gender)
c) Temperament and beliefs of fund manager
Next, we will explore some of the more common investment styles.
Active versus Passive
Investors with an active investment style believe in their ability to outperform the overall market by selecting stocks that may perform well. Many believe markets are not always efficient and investors can potentially profit by uncovering undervalued stocks through research. Most mutual funds follow an active investment style.
The passive investment style, on the other hand, believes results can be achieved simply by investing in a market index. Passive investors believe in market efficiency, where all information available about a company is already priced into that stock’s current price, thus forecasting on future stock prices is of little value. Exchange traded funds (ETFs) and index funds are instruments that are passively managed.
Growth versus Value
Active investors can be divided into growth and value seekers.
Growth investors usually look for companies with great projected earnings growth, supported by a solid history of earnings improvement. They are usually prepared to buy the stocks at high valuations because they believe higher earnings growth will be sustainable in the near future. Growth stocks tend to be susceptible to investor sentiments and hence more volatile.
On the other hand, value investors (also known as contrarian investors) usually look for bargains — stocks that are cheap compared to their intrinsic valuation. Hence, such stocks usually trade on low P/E ratios relative to the projected earnings growth rate and have low price to asset ratio as well. Famous investment guru, Warren Buffett, is a firm believer of value investing.
Growth At Reasonable Price (GARP)
The GARP investment style is a combination of value and growth styles. Fund managers following the GARP investment style usually look for companies with consistent earnings growth above that of broad market levels (a core attribute of growth investing ) while excluding companies with P/E ratios that are too high (a core attribute of value investing).
The GARP investment style was made famous by legendary fund manager, Peter Lynch, who grew Fidelity Magellan Fund from US$18 million in assets to more than US$14 billion in assets over a span of 14 years - an annualised return of 29.2%.
Small Caps versus Large Caps
Some fund managers focus exclusively on companies with a certain market capitalisation. Small caps refer to companies with small market capitalisation and often fund managers buy into small caps with the expectation of higher growth. However, risk associated with small caps is also high.
Large cap investors often seek sustainable returns at lower risk levels. Funds with a longer investment horizon, such as pension funds, use this investment style to meet the investment objectives set out by the fund trustee.
Technical versus Fundamental
Some fund managers follow the technical investment style. Technical investing involves using price data and charts to predict future pricing trends. They are usually more concerned with short-term market timing and use technical indicators to determine entry and exit prices.
Fundamental investment style followers prefer to research the fundamentals of the company before making investment decisions. They tend to look for stocks with strong financial numbers and growth potential.
Apart from helping you identify an investment style that works for you, we believe knowing about the different investment styles will help you interpret investment decisions of your fund managers better. This should also make some of the expert speak on the markets easier to understand. Happy investing!