Bogle: On Equity Styles

Chapter 6 of "Common Sense on Mutual Funds" is a discussion of investment style, returns, and relative index fund performance.

Over the last 30 years, academic research into the US stock market has shown that the whole US stock (equity) market can be dissected into various sectors that have there own risk and return characteristics. Below is a short excerpt from www.Investopedia.com that explains the most common style box:

The domestic equity style box, designed to assist in the evaluation of securities, is the best-known and most popular type of style box. Morningstar's domestic equity style box, shown below, provides a simple equity classification system.
The vertical axis of the style box is divided into three categories, which are based on market cap. For mutual fund evaluations, Morningstar's proprietary market cap evaluation methodology is used to rank the underlying stocks in each mutual fund in order to determine the fund's market cap. Of the 5,000 stocks in Morningstar's domestic equity database, the top 5% are categorized as large cap. The next 15% are classified as medium cap and the remaining stocks are classified as small cap.

The horizontal axis is also divided into three categories, based on valuation. Once again, the underlying stocks in each mutual fund portfolio are reviewed. The price-to-earnings (P/E) andprice-to-book (P/B) ratios are used as the basis of a mathematical calculation that results in the classification of each stock as growth, blend or value. "Blend" is used to describe stocks that exhibit both growth and value characteristics.

Analysis of the style boxes will show an investor that the smaller the sector the higher the return. Likewise, value funds outperform growth funds. In addition, as style drifts towards smaller and value, risk increases.

Understanding this breakdown is important for a couple of reasons;

1. It allows an investor to understand why and how their mutual fund performance is behaving in a certain manner. For example, over time, a small value fund should outperform a large growth fund - because it is riskier.

2. It helps explain manager performance. For many years, a mutual fund (or portfolio manager) was evaluated on pure returns. Now funds are reviewed through the risk and style box lens. A fund manager who focuses on small value and outperforms the total market will be evaluated against other small value measures not the whole market. So managers can no longer outperform by taking higher risks.and be perceived as being smarter than the market.

Next post I will explore how index funds compare against active managers in each style box.