A Matter of Style

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A Matter of Style
by Justin Holt, CFA, Senior Research Analyst, Schwab Center for Financial Research
Updated November 4, 2008

Updated from the October 2007 issue of Schwab Investing Insights®, a monthly publication for Schwab clients.

Like fashion, investment styles move in and out of favor, sometimes abruptly. After seven years of underperforming value funds, growth funds may be poised to seize center stage, as value funds, heavy in the battered financials sector, have been selling off amid subprime fears. Now, investment gurus are sparring over how long a technology-led growth cycle might last. But for long-term investors, a far better question is: Does your portfolio have the right mix of value and growth—or is it time for a style makeover?

As you can see in the graph below, style leadership rotates. Value cycles have generally lasted longer than growth cycles. Indeed, as of September 30, 2008, value has outperformed growth throughout the trailing five-, 10- and 20-year periods, with considerably less volatility.¹ But that's hardly a call to abandon growth, which has outperformed in short, intense bursts. For the three-year period ending in March 2000, growth beat value by 92 percentage points!² And though it's too soon to say when this value cycle will end, based on the most recent trailing three-year return differential between the Russell 1000 Value and Growth indexes, growth appears to be catching up.³

As of September 30, 2008. Three-year return difference starting from January 1, 1979, of Russell 1000 Value Index minus Russell 1000 growth Index with dividends reinvested. Recession data from National Bureau of Economic Research.

In the short term, markets can move quickly and unpredictably—and it's difficult, if not impossible, to predict the direction and timing of those moves correctly. That's why we generally recommend a 50/50 split between growth and value, though you may want to make marginal adjustments to meet your personal needs. A value tilt may be appropriate for investors who wish to participate in the stock market but want to minimize their exposure to economic swings. A growth tilt may be favorable for those willing to take on more risk for the potential of significant capital appreciation. And you can make tweaks within each style allocation, too. For example, an income-seeking retiree may wish to concentrate his or her value allocation in dividend equity funds to increase yield and lower risk.

Growth vs. value: What's the difference?
Although growth and value funds come in many flavors, the styles have distinct characteristics.

Growth funds attempt to identify companies that can grow earnings, revenue or cash flows faster than the market averages. Growth funds tend to soar during economic booms, such as the late 1980s and late 1990s, and lag during downturns. Historically, growth funds have been less tax-efficient than value funds due to their higher portfolio turnover, but that trend could reverse in the near future. Large-growth managers are now sitting on average unrealized capital losses of 26% of portfolio value, which could offset future capital gains and improve tax efficiency.
Value managers focus on a company's fundamentals—such as the relationships of book value and earnings to price—and look for opportunities to buy "bargain" stocks with valuations higher than their market prices, expecting this to reverse later (to prices higher than their valuations). Value tends to shine during economic downturns and even early in expansions, though this cycle may vary. Growth can overtake value on the way back up.
Blend—a style-neutral category—entails investing in both growth and value. Some funds may be appropriate as strong core holdings because they follow a strategy of operating firmly in the blend category whereas others occasionally stray to blend from their homes in value or growth. Some even migrate through blend to the opposite style. So with blend funds, it's particularly important to look under the hood to understand your fund's style makeup. Those drifters can wreak havoc with your total portfolio style balance; a consistent blend fund won't. Indeed, watch out for excessive migration among all fund styles. The Schwab Center for Financial Research found that of the 1,853 large-growth funds in existence today, only 265 had followed large-growth strategies in every month since January 2000—showing a lot of style drift in large-cap funds.⁴

What style fits your needs?
Here are two growth and three value styles, from aggressive to conservative, and how you might use them in your portfolio:

Aggressive growth funds seek a high level of capital appreciation by investing in stocks that are expected to generate well-above-average earnings growth. This high-risk strategy often depends on the short-term momentum of a few industries or sectors but can pay off during strong rallies. Also, it often entails investing in upstart, innovative companies with minimal tangible assets, no earnings track records and rich stock valuations (e.g., solar power, ethanol and other "cleantech" companies).
Growth at a reasonable price (GARP) funds straddle value and growth and, as a result, are sometimes categorized as blend rather than growth. They invest in companies growing at a sustainable rate above the market and trading at underappreciated prices. Like value funds, GARP funds can preserve capital in recessionary periods but lag more aggressive growth strategies during growth booms.
Deep value is an aggressive strategy of buying stocks with extremely low valuation measures, such as low price-earnings (P/E) or price-book (P/B) ratios, with the hope of a turnaround (think real estate investment trusts [REITs] and home builders now). But watch for concentrations: Deep value is typically driven by the outcomes of a few out-of-favor sectors.
Relative value managers buy stocks that are underappreciated relative to the market or peers within their sector. The most common value approach, relative value funds tend to be more diversified than deep value funds. This strategy provides upside with less exposure to sector- and company-specific business risk and can help preserve capital during market downturns.
Dividend equity funds follow a more conservative strategy of buying the stocks of mature companies with stable cash flows. Best for income seekers, these funds lag other styles in up markets but provide greater shelter in volatile times. Beware of taxes: A lot of the returns come from nonqualified dividends (taxed at federal income tax rates up to 35%), not capital gains (taxed at a top 15% rate for long-term holdings).⁵

As you size up new funds or decide whether to hold on to an existing fund, remember to take into account whether that fund's style has been in or out of favor. As an example, when we evaluate funds for Schwab's Mutual Fund OneSource Select List®, one of the things we consider is a fund's risk- and style-adjusted performance relative to that of its peer group over multiple time periods. We do this style adjustment so that we don't unfairly penalize a large-growth fund for underperfoming the broad index if all growth funds were underperforming during that time period. And we adjust performance for risk because you probably wouldn't want a fund to shoot the lights out performancewise if that came with heightened volatility. Take a look at the table below for funds with reasonable risk-adjusted performance that we think have stayed true to their style. If you're a client, log in to Schwab.com/selectlist for more fund ideas.

What Combination of Large-Cap Fund Styles Is Right for You?
If you …	… Then consider these funds	What these funds hold now
Are looking for a strong core holding to anchor your portfolio or have a small dollar amount to invest	Blend: Schwab Core Equity Fund™ (SWANX) or Federated Capital Appreciation (FEDEX)	Broadly diversified across sectors and industries
Have a long time horizon or can stomach volatility in exchange for capital growth	Aggressive growth: Janus Research (JAMRX)	Technology (24%), healthcare (13%)
Prefer slightly less economic risk but still want to grow your investment	GARP: SIT Large Cap Growth (SNIGX) Relative value: Wells Fargo Advantage C&B Large-Cap Value (CBEQX)	Energy (18%), materials (14%) Financials (21%), materials (18%)
Are retired and would like some income as well as moderate growth	GARP: Schwab Large-Cap Growth (SWLNX) Dividend equity: Parnassus Equity Income (PRBLX) or Schwab Dividend Equity Fund™ (SWDIX)	Aerospace and defense (Boeing 5%, Lockheed Martin 5%) Materials (15%), healthcare (15%) Financials (16%), materials (15%)
Want professional managers to keep your fund portfolio rebalanced and style-neutral	Schwab Managed Portfolios™	Customized combinations of blend, growth and value styles across large- and small-cap funds
Source: Schwab Center for Financial Research. Data from Morningstar as of August 31, 2008.

If you're a do-it-yourselfer and a Schwab client, log in to schwab.com/funds, enter a ticker and click on the Performance tab. Then, take a look at how your fund has performed against its category peers in multiple years, remembering to look in both value- and growth-led cycles (as shown in the "Stay Balanced" graph).

Finally, remember to periodically rebalance back to your target allocation. Consider an investor who started in 2000 with an even 50/50 allocation to large-cap value and growth. As illustrated by the "Stay Balanced" chart above, left unchecked through July 2007, that portfolio would have drifted toward a significant value tilt and would have missed out on the ensuing rebound in growth since that time.⁶

The bottom line
We recommend holding both growth and value funds for the long term. And though yellow and blue can make a lovely green, when it comes to investing, there are benefits to holding distinct growth and value funds: In different economic cycles, some styles have historically preserved capital better; some have provided income more consistently; and some were more attractive for your tax bill.

If you are an active investor who is worried about the value cycle ending and you are looking to make small, short-term tweaks, consider GARP funds, as their reduced exposure to subprime and financials may benefit investors in a recession or growth slowdown, and they generally have a bias toward higher-quality stocks.

Important Disclosures

Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.

Past performance is no guarantee of future results, and your investment value and return will fluctuate such that shares, when redeemed, may be worth more or less than original cost.

The current and future portfolio holdings contained in a mutual fund is subject to risk you should be aware of prior to making an investment decision.

Approximately 2,100 funds participate in the Mutual Fund OneSource® service. Only these funds, including Schwab Affiliate Funds, are eligible for the Mutual Fund OneSource Select List. Schwab receives remuneration from fund companies, and/or their affiliates, in the Mutual Fund OneSource service for recordkeeping, shareholder services and other administrative services.

The aggregate fees Schwab or its affiliates receive from Schwab Affiliate Funds (see fund prospectuses for more details) are greater than the remuneration Schwab receives from fund companies participating in Schwab's Mutual Fund OneSource service.

Please read Schwab's Schedule H of Form ADV for important information and disclosures relating to Schwab Managed Portfolios.

1. Using Russell 1000 Growth Index and Russell 1000 Value Index, with dividends reinvested, value had 8% less volatility than growth for the five-year period, 27% less for the 10-year period and 22% less for the 20-year period.
2. Using Russell 1000 Growth Index and Russell 1000 Value Index, with dividends reinvested.
3. Using Russell 1000 Growth Index and Russell 1000 Value Index, with dividends reinvested, through September 30, 2008.
4. Data from Morningstar® as of June 30, 2007, adjusted for survivorship bias.
5. Nonqualified dividends are taxed at ordinary income tax rates, which go as high as 35%; capital gains and qualified dividends are taxed at a top rate of 15%.
6. Using Morningstar large-growth and large-value category mean-returning funds, with dividends reinvested and no rebalancing.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Past results are not indicative of future performance.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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