Stock markets are inherently inefficient; their composition and the drivers of risk and return within them change over time. But, while some fund managers focus on exploiting one type of inefficiency, be it growth, value or some other factor, markets are inefficient in all these areas. Fund managers who align themselves to one style are denying their clients a wide range of opportunities to generate strong and consistent returns. 
Styles are in effect a shortcut, a useful taxonomy bucket, to help identify inefficiencies due to investors’ behaviour patterns. The industry’s journey in defining investment edge and market inefficiencies around style factors goes back to the original three factors identified by investment theorists Eugene Fama and Kenneth French in the early 1990s. Those were market beta, market cap/size and value.
The Fama-French model was later expanded to include profitability and return on investment, or quality, and then momentum. Through a blend of marketing and sophisticated quantitative analysis, factor investing morphed into smart beta, offering factors as investable products.
Single-style advocates always point to empirical evidence to prove their argument. But sticking to just one style factor limits your opportunity set. Clients are better served through capturing a wider array of inefficiently priced stocks. Our goal is to find companies with fundamentals that are mis-forecast by the consensus, whichever category they belong to.
Cyclically challenged: Falling in and out of style
To look at things another way, quality and growth have done well in recent years and value has done badly. There are many drivers of this cyclicality. Some relate to the macro environment; others relate to the fact that business models have changed across an array of industries, meaning traditional fundamental metrics are outdated and no longer capture specific factors as they should.
Intangible assets are a case in point. In many industries, leading companies now rely on intellectual property, employee and customer loyalty, brand or the power of network effects to succeed. The resulting increase in intangible investment over recent years has led to accounting deficiencies that are effectively mis-specifying book values and earnings.
Further compounding things is the fact that many non-R&D (research & development) intangible investments, such as in IT and human resources, are included as sales, general and administrative expenses in companies’ income statements and not reflected in some traditional value metrics. This makes style definitions based on filtering fundamental metrics through a methodology unchanged over a long period of time somewhat suspect.
Figure 1 illustrates this phenomenon. As a bigger proportion of companies’ asset values is no longer captured by tangible book value, the traditional book-to-price metric used in the original Fama-French model loses some of its relevance.
Figure 1: The declining importance of tangible assets
Source JP Morgan
Another problematic aspect of style-driven investing is the cyclicality and volatility of factor performance, as illustrated by figure 2.
Figure 2: Style factor relative performance
Source: JP Morgan
Somewhat predictably, the bar chart shows factor investing is cyclical in the sense that it works for a while and then it doesn’t, even if this mean-reversion can sometimes take a while to show through, as has been the case with value investing recently. However, when the reversion to the mean finally comes, those on the wrong side of the trade will find it painful.
Style-driven investing condemns managers (and more importantly their clients) to be permanently exposed to one factor’s performance volatility. Advocates of diversification should bear this in mind.
Connected thinking: Why style-agnostic investing improves fundamental research
Holistic research of a company is necessary to understand it fully. Take the example of video streaming versus pay-TV, a prominent change in the media industry made more relevant by the Covid-induced stay-at-home trend.
One should analyse Netflix, Disney or Comcast and legacy media content providers such as Discovery Inc to gain a full understanding of the matter. These businesses are all inextricably linked in the supplier, customer and competitor relationship web that is central to the transition from cable to satellite to over-the-top video streaming. To gain complete insight into this dynamic, a manager needs to understand all of them. But to do that well requires research of a growth stock, a value stock and a quality stock. Importantly, this must all be done without prejudice.
This is where a style-agnostic approach brings a research advantage. It creates scope to cover broader ground and understand the changes taking place to ultimately identify the right non-consensus idea. It brings an understanding of the company and its value chain, peers, customers and suppliers.
Best of the best
To fully understand the change affecting these companies and find the instance where this change is most mispriced and will lead to the most compelling upside, managers should research the whole value chain, not limit themselves to one sub-segment.
Constructing a portfolio across sectors and regions will mean it is not linked to any one style. Whichever way factors move, the portfolio should be less affected overall. In contrast, an investor limited to one style factor is unlikely to have the resources to do in-depth research on companies that fall outside of the style bucket, making the portfolio less aligned to constantly-evolving industry dynamics.
The objective for any fund manager should be to deliver repeatable and sustainable outperformance for their clients. An approach that offers flexibility to explore a broader opportunity set, avoids risks endemic in single-style investing and gains a research and informational advantage by understanding companies and their changing fundamentals across regions and sectors, provides the best opportunity to deliver on this objective.
Mikhail Zverev is head of global equities at Aviva Investors. The views expressed above are his own and should not be taken as investment advice.