Equity styles and your unconscious exposure

How are the different equity styles likely to perform, and is there an equity style you should favour over another? We explore the different styles, what impacts their performance, and what's likely to happen next.

Recent years have brought significant changes to the investment backdrop.  

As well as increases in gilt yields and credit spreads, 2022 also saw the end of an almost 15-year run of growth stocks outperforming value stocks.  

We consider which of these styles are more likely to outperform in certain economic environments, and why now may not be the right time to express a strong bias on an equity style. 

Economic styles: what is 'growth' and 'value'?

Investment managers will often refer to investing in a particular ‘style’ of equities. The terms ‘growth’ and ‘value’ are used frequently, but people rarely define them in the same way: 

Of course, companies can shift between style as their strategies or market perception of their outlook change.

Sector trends can be seen below through the relative weights of growth and value by sector, relative to the MSCI world index:
 

What impacts the performance of stocks?

In 2022, the market broke its growth outperformance trend as we saw a rotation in value stocks amid market uncertainty. This quickly reverted to growth outperformance at the start of 2023, demonstrated in the graph below: 

These recent shifts highlight the difficulty in timing the market benefit from a particular style. However, we have identified trends in the market and how we anticipate what impacts value and growth.

Historically, growth stocks have outperformed when interest rates and inflation have been low or falling. Growth stocks rely on strong future growth to drive increases in earnings.

Value funds have outperformed in periods of rising inflation and interest rates. Value stocks rely on short-term earnings and so are less affected by changes in growth expectations.

What might happen next? 

Using historical trends observed since the mid-1970s, we have identified three economic scenarios to help predict which style will outperform in the future.

Scenario 1: Continued high inflation | value outperformance

In this scenario, inflation remains above target and central banks must raise interest rates further to try and bring it under control. We believe a backdrop of uncertainty favours value approach and is comparable to the 1970s and 1980s, when inflation and interest rates remained high and value steadily outperformed.  

Scenario 2: recession | growth outperformance

In this scenario, the rise of central bank rates force the global economy into recession, bringing inflation to below target. Central banks would likely respond by cutting interest rates which we would expect to stimulate growth in the economy. A comparable period would be the years following the global financial crisis - central banks cut rates close to zero to limit the damage from the recession and despite slow growth, low borrowing costs helped growth outperform.

Scenario 3: soft landing | no clear winner

A soft landing is when the central bank can bring inflation under control with rising rates, while avoiding a recession with interest rates remaining high. In this scenario, it’s not clear whether growth or value will outperform. Growth style investing will be hurt by the realisation that cheap borrowing will not return but will also benefit from future growth expectations. As such, there is no clear winner and striking a balance between both styles helps to diversify this risk. The mid-1990s is the most comparable period - there was a period of value outperformance as rates rose, and growth recovered shortly after. 

What impact does this have on clients' portfolios?

For equity funds with style tilts the impact may be significant and we would expect a reasonable amount of the performance to be attributable to the investment style. 

However, the investment styles of Diversified Growth Funds (DGF) typically are less affected due to the smaller equity holding, between around 20-60%. There is also no need to pick a side and we see plenty of managers that actively take out any style biases in portfolios.

We’ve analysed numerous DGFs and how an asset manager style bias could impact their long-term returns. For most funds over the long-term, we do not expect the style to be a significant contributor or detractor to returns. However, it is important that consultants and clients are aware of any style biases within equity or DGF portfolios to ensure they can understand how performance could vary over the shorter term. 

Key takeaways for investors

There are market conditions that are more supportive of growth styles and others that are more supportive of value styles. However, there continues to be uncertainty over which of these scenarios will come to pass and within what timeframe. The key takeaways are:

For defined benefit (DB) investors:

Many DB schemes saw an improvement in their funding position due to market movements in 2022. The general trend is that schemes are now notably closer to their end goal. For DB investors, the potential shorter timeframe to buyout means that it may no longer be appropriate to invest in a fund with a dominant style as there is less time (and a smaller asset pool) to recover in the event of any significant resulting underperformance.

For other long-term investors (defined contribution, charity and endowment):

It’s important to remain aware of style biases and be active in your selection of them. Your investment consultant will be able to assist you in determining any bias within your portfolio, so that you can make an active decision on whether to maintain it, informed by the impact it might have on your overall returns. As part of this, investors should consider whether they have the governance structure in place to change manager if the economic outlook changes. 

Visit our investment services page to find out how our experts can help.