Investment Styles
Investment style refers to the approach used to select securities and construct portfolios. Understanding different styles helps advisers match strategies to client needs and market conditions.
Growth vs. Value Investing
The growth-value distinction is one of the most fundamental in investment management.
Growth Investing
Definition: Investing in companies with above-average earnings growth expectations, even at higher valuations.
| Characteristic | Description |
|---|---|
| P/E Ratio | High (typically 25-40+) |
| Dividend Yield | Low or none (earnings reinvested) |
| Revenue Growth | 15%+ annual growth expected |
| Industries | Technology, healthcare, consumer discretionary |
| Volatility | Higher |
Growth Investor Mindset:
- Willing to pay a premium for future growth potential
- Focus on revenue growth, market share expansion
- Less concerned with current profitability
- Expects capital appreciation, not income
Typical Growth Metrics:
- Price-to-Earnings Growth (PEG) ratio
- Revenue growth rate
- Earnings growth rate
- Return on equity (ROE)
Value Investing
Definition: Investing in companies trading below their intrinsic value, often identified by low valuation ratios.
| Characteristic | Description |
|---|---|
| P/E Ratio | Low (typically 10-15) |
| Price-to-Book | Often below 1.0 |
| Dividend Yield | Higher (company returns cash) |
| Industries | Financials, utilities, industrials |
| Volatility | Lower (typically) |
Value Investor Mindset:
- "Margin of safety" philosophy (buy cheap)
- Patience—wait for market to recognize value
- Focus on fundamentals vs. market sentiment
- Often contrarian (buy what others are selling)
Typical Value Metrics:
- Price-to-Earnings (P/E) ratio
- Price-to-Book (P/B) ratio
- Dividend yield
- Free cash flow yield
Growth vs. Value Performance
| Market Condition | Typically Favored Style |
|---|---|
| Bull market/expansion | Growth |
| Bear market/recession | Value |
| Rising interest rates | Value |
| Falling interest rates | Growth |
| Low inflation | Growth |
| High inflation | Value |
Important: Neither style consistently outperforms—they cycle. A diversified portfolio often includes both.
Active vs. Passive Management
Active Management
Definition: Attempting to outperform a benchmark through security selection and/or market timing.
| Feature | Description |
|---|---|
| Goal | Beat the benchmark |
| Approach | Research-driven stock selection |
| Trading | Frequent (higher turnover) |
| Expense Ratio | Higher (0.5% - 1.5% typical) |
| Tax Efficiency | Lower (more taxable events) |
Arguments FOR Active Management:
- Skilled managers can identify mispriced securities
- Can avoid overvalued stocks
- Flexibility to respond to market conditions
- May add value in less efficient markets
Arguments AGAINST Active Management:
- Most active managers underperform over time
- Higher fees compound negatively
- Tax inefficiency hurts after-tax returns
- Difficult to identify winning managers in advance
Passive Management (Indexing)
Definition: Matching the returns of a market index by holding its constituent securities.
| Feature | Description |
|---|---|
| Goal | Match the benchmark |
| Approach | Buy and hold index components |
| Trading | Minimal (only for rebalancing) |
| Expense Ratio | Lower (0.03% - 0.20% typical) |
| Tax Efficiency | Higher (fewer taxable events) |
The Evidence on Active vs. Passive:
| Time Period | % of Active Large-Cap Managers Underperforming S&P 500 |
|---|---|
| 1 Year | ~60% |
| 5 Years | ~75% |
| 10 Years | ~85% |
| 15 Years | ~90% |
The Cost of Fees
| Expense Ratio | $100,000 After 30 Years (7% return) |
|---|---|
| 0.10% (passive) | $745,000 |
| 1.00% (active) | $574,000 |
| Difference | $171,000 lost to fees |
Market Capitalization Styles
Large Cap (> $10 billion market cap)
- More established, stable companies
- Greater liquidity and analyst coverage
- Generally lower volatility
- Dividends more common
Mid Cap ($2-10 billion)
- "Sweet spot" of growth and stability
- Less analyst coverage than large cap
- Moderate volatility
Small Cap (< $2 billion)
- Higher growth potential
- Less liquidity, more volatility
- Less analyst coverage
- Greater risk of business failure
Geographic Styles
| Category | Characteristics |
|---|---|
| Domestic | Home currency, lower complexity |
| Developed International | Europe, Japan, Australia—diversification benefits |
| Emerging Markets | Higher growth potential, higher risk, currency exposure |
In Practice
Most portfolios blend multiple styles:
- Core-satellite: Passive core + active satellite positions
- Style diversification: Growth AND value exposure
- Cap diversification: Large, mid, and small cap
- Geographic diversification: Domestic and international
On the Exam
Series 65 frequently tests:
- Distinguishing growth (high P/E, low dividends) from value (low P/E, higher dividends)
- Understanding active vs. passive management trade-offs
- Knowing that most active managers underperform over time
- Recognizing which styles may outperform in different market conditions
Key Takeaways
- Growth stocks have high P/E ratios; value stocks have low P/E ratios
- Growth tends to outperform in bull markets; value in bear markets
- Most active managers underperform their benchmarks over time
- Passive management has lower costs and greater tax efficiency
- Fees compound negatively—a 1% fee difference costs significantly over time
- Diversification across styles reduces timing risk
A stock with a high P/E ratio, low dividend yield, and expected earnings growth of 20% per year would most likely be classified as a:
Over a 15-year period, approximately what percentage of actively managed large-cap funds underperform the S&P 500 index?
The primary advantage of passive index investing over active management is:
10.2 Portfolio Management Techniques
Continue learning