Style is a widely used term to define a particular investment approach. Different styles have different historical risk-reward characteristics. Mixing styles in an individual’s portfolio is often recommended as a means to achieve diversity and improve performance.
Style ETFs are designed to track a particular investment style and/or asset class. Asset class ETFs include small-cap, medium-cap, and large-cap stocks. Investment style ETFs include value and growth. The market cap and investment style can be combined into approaches, such as small-cap value, large-cap growth, and so on.
Small, mid, large cap
Briefly, a large-cap stock refers to a company with a market capitalization of more than $10 billion. A mid-cap stock refers to a company with a market cap between $2 billion and $10 billion. And a small-cap stock generally refers to a company with a market cap of $300 million to $2 billion.
Market cap performance varies over time. Looking at market history, small- and mid-cap stocks have tended to outperform large-cap stocks for extended periods of time. However, the performance differential is small and has completely evaporated during certain periods.
To the degree that there is a performance bias in favor of small-cap stocks, 3 explanations are offered: (1) Small-cap stocks are disproportionately held by smaller investors who often sell stock late in the calendar year for tax reasons. Accordingly, after the late year sell-off, small-cap stocks tend to rebound in January. This is known as the January effect. (2) Small-cap companies are more likely to go out of business and thus the indexes tracking small-cap stocks are over-weighted with the stronger companies that have survived. (3) Small-cap companies are the growth engine of the economy and a small number generate extraordinary earnings growth, lifting the entire category.
Investors should be aware that many leading equity indexes such as the S&P 500, the Russell 1000 and the Russell 3000 are constructed via a market capitalization method which means they tend to be top-heavy in large-cap market stocks. Thus, they will perform better when large caps are doing well and will suffer when small- and mid-cap stocks are outperforming larger stocks. To strike more of a balance between capitalization sectors in an index fund an investor may want to consider index funds constructed via an "equal weight" method, which gives equal weight to small and large companies.
There are hundreds of ETFs to choose from in each of the market cap categories: small, mid, and large. You can customize a portfolio to achieve equal balance between market cap categories or to weight your portfolio to a particular sector. Given historic performance tendencies, a long-term investor may want to consider weighting their portfolio slightly toward small- and mid-cap sectors, although investors should always remember that past performance is not indicative of future results.
Value versus growth
Value versus growth investing styles have generated many arguments and much research among investors as to which is the better approach.
Value investors buy companies whose shares appear to be underpriced relative to the company's financial performance as reflected in the company's price-to-earnings ratio, dividend yield, or price-to-book ratio. The most famous value investor in recent times is Warren Buffett.
Growth investors focus on companies that are growing at a fast rate and are expected to generate earnings growth in excess of the overall market and their industry sector. Peter Lynch, who achieved spectacular results as manager of Fidelity's Magellan Fund, coined the phrase "growth at a reasonable price" which was something of a hybrid of the value and growth approach.
Vanguard CEO John Bogle, in his book Common Sense on Mutual Funds, studied performance data for mutual funds from 1937–1997 and concluded that: "For the full 60-year period, the compound total returns were: growth 11.7%; value 11.5%—a tiny difference." Bogle updated the data through May 2006 and reported a performance differential of just .03%, again a paltry amount.
But while over long periods of time, the performance differential of investment styles tends to converge, there are shorter periods where one style substantially outperforms another style. Investors nimble enough to overweight their portfolios to those styles can generate market-beating returns.
While style ETFs enable investors to weight their portfolios in favor of a particular investment style, it should be noted that picking winning investment styles is very difficult. Perhaps the chief value that style ETFs bring to investors is the ability to balance their style exposures in way that maximizes risk-adjusted growth.