Style Factor Exposure

Portfolio Creation Process

There are four drivers of performance in your portfolio. In this series, we will look at each in detail, providing insights into how we build portfolios.

Style factor exposure is the second article in this series. To read the other articles, click here.

The portfolio creation process

Style & factor bias in the equity allocation of your portfolio

When we analyse our investment offering, we want to understand the drivers of risk and return in our portfolios and to make sure that we are being compensated for the risks that we are taking. One way that we can use to do this is to assess the “style” bias of our portfolios.

Style analysis splits the market into overlapping groups based on the characteristics of individual stocks. These characteristics may include valuation metrics (such as price to book), company size (market capitalisation), or growth-based metrics (earnings or sales forecasts). Each style can behave differently in given market circumstances and depending on our view we can bias our portfolios towards one or more styles to take advantage of this. 

Styles can be accessed via systematic, or rules-based, strategies. Index providers can very quickly filter the market for stocks with a low price to earnings ratio for example, and track the performance and risk that is produced by this simply owning these names. This brings two broad advantages.

First, investors have access to a cost-effective way of making active decisions as style index funds are available at similar costs to other passive index funds.

Secondly, by understanding the level of risk and return that we can expect from a rules-based strategy, we can better scrutinise the returns of managers that are being paid to make active decisions. It helps us to assess how much of a funds return came from their stock-picking ability versus simply buying stocks with similar characteristics. 

What factors do we look for?

There are several different investment styles used by investment managers. The most common are:

• Value: Investing in stocks that are “cheap” compared to their book value (net difference between a company’s assets and liabilities) or relative to the rest of the index.
• Growth: Searching for companies whose earnings are expected to increase at an above-average rate compared to their industry sector or the overall market.
• Quality: Investing in companies with more stable cashflows, higher return on assets and consistent earnings growth.
• Low volatility: Identifying stocks that experience, on average, smaller price fluctuations than the broader index.

Quality is a core element of our portfolio strategy. While we assess all style exposures in portfolios relative to a global equity benchmark, we have favoured a bias towards quality for several years. Metrics we look for include long-term profitability, high return on assets, and consistent earnings and sales growth rates. To help with our assessment of these within portfolios, we have invested in several analytics tools to help us analyse the exposure in your portfolio to these attributes. This ensures we maintain consistent oversight of the return drivers that we believe will add long term value.

Investing in quality might seem obvious, simply buy the best companies. So why doesn’t everyone do it?

First, the best companies tend to be more expensive. Benjamin Graham, an American economist and author of the book ‘The Intelligent Investor’ which has been described as the best book on investing ever written, is credited with the observation that the greatest losses result not from buying quality companies at an excessively high price, but from buying low quality companies at a price that seems good value. Overpaying for companies can still have an adverse impact on your future returns therefore it pays to be selective.

Secondly, there is no commonly accepted industry definition of quality investing. Most definitions of quality involve some combination of harder data (return on equity, stability of growth, balance sheet strength), with softer data (brand power, management capabilities, product strength) and fund managers have their own unique interpretations on the best way to combine the metrics. 

We believe that the best way to implement a quality bias in our portfolios is through a blend of high conviction active managers. This allows us to gain exposure to our preferred quality metrics, rather than the quality definition of an individual manager or index. We have selected experienced managers who have strong track records in accurately making these assessments but who also have displayed a strong commitment to a distinctive investment philosophy. This allows us to build a portfolio that is selective at the holdings level, while also having exposure to a variety of the complementary components of quality.

If you would like to hear more about how our team of investment experts can help you build an investment strategy to meet your goals, please contact our office on +44 (0) 2890 310 655 and request a call with one of our Davy UK Wealth Managers.

To read more about the four sections of the portfolio creation quadrant, click on the articles below.

Strategic Asset Allocation

Your most important decision, how we help you arrive at an appropriate allocation and the implications for your long-term objectives.

Read about strategic asset allocation

Style Factor Bias

The group of characteristics that we look for in the stocks that underlie your portfolio.

Read about style factor bias

Instrument Selection

The final part of portfolio construction, the individual instruments that convey our views.

Read about instrument selection

Tactical Asset Allocation

How we invest your money with shorter term risks and opportunities in mind.

Read about tactical asset allocation