U.S. Style Box ETF Rotation – Introducing Portfolio Cafe’s newest ETF model.

In 1992 Morningstar introduced their now famous “style box” as a way to classify  mutual funds into distinct categories based upon market capitalization and growth and value characteristics.   In this article I will introduce Portfolio Cafe’s newest ETF model which is based upon the observable performance differential between investment styles.  But first, some quick background.

How it Works – Quantitative Ranking

The vertical axis of the Style Box defines three size categories, or capitalization bands-small, mid-size, and large. The horizontal axis defines three style categories. Two of these categories, “value” and “growth,” are common to both stocks and funds. However, for stocks, the central column of the style box represents the core style (those stocks for which neither value or growth characteristics dominate); for funds, it represents the blend style (a mixture of growth and value stocks or mostly core stocks).

Style Box assignments begin at the individual stock level. Morningstar determines the investment style of each individual stock in its database. Stocks are evaluated against other stocks in the same geographic area (United States, Latin America, Canada, Europe, Japan, Asia ex-Japan, Australia/New Zealand). The style attributes of individual stocks are then used to determine the style classification of stock mutual funds.

The Horizontal Axis

  • The scores for a stock’s value and growth characteristics determine its horizontal placement:
  • Value Score Components and Weights
  • Forward looking measures 50.0%
  • Price/Prospective Earnings.
  • Historical based measures 50.0%
  • Price/book 12.5% Price/sales 12.5% Price/cash flow 12.5% Dividend yield 12.5%
  • Growth Score Components and Weights
  • Forward looking measures 50.0%
  • Long-term projected earnings growth
  • Historical-based measures 50.0%
  • Historical earnings growth 12.5% Sales growth 12.5% Cash flow growth 12.5% Book value growth 12.5%

The Vertical Axis

Rather than a fixed number of “large cap”or “small cap” stocks, Morningstar uses a flexible system that isn’t adversely affected by overall movements in the market. Large-cap stocks are defined as the group that accounts for the top 70% of the capitalization of each geographic area; mid-cap stocks represent the next 20%; and small-cap stocks represent the balance.

Style Boxes as Factors

While style boxes have served usefulness in classifying mutual funds, I would pose that they also represent another example of where “rotation” is observable and where rotation strategies can produce excess returns.  Since each style box represents a concentration of stocks of similar characteristics, it’s fair to treat  each style box as a factor.

The financial literature is filled with numerous examples of where momentum strategies have been used to produces excess returns in virtually every asset class and their respective parts. (sectors, industries, countries).   Momentum strategies are equally applicable to equity styles.

In 2008, Tibbs, Eakins, and DeShurko published  “Using Style Index Momentum to Generate Alpha” which examined the effect of momentum using Russell style box classification.  The results indicated that momentum does indeed persists when applied to equity styles, just the same as when applied to other forms of classification.  That is, the performance of the top-ranked equity style tends to persist.  The top-performing style typically displayed the best performance and the bottom performing style continued to display the worst performance.

For investors, this is good news as the use of Russell style box ETFs represents a very easy and low-cost means to gain diversified access to the U.S. stock market.  For example, the iShares Russell 1000 Value ETF (IWD) presently holds 669 stocks classified as large-cap value.  Names like Exxon-Mobile, AT&T, Chevron, Procter & Gamble, and Berkshire Hathaway, Inc. are among its top holdings.

Building a Better Model

The addition of the style-based momentum model to the Portfolio Cafe lineup provides investors with a very affordable and effective means to invest in the U.S. market.  In addition to including an ETF representing each of the Russell primary style boxes, I have added a handful of other ETFs including the iShares DJ Select Dividend Index (DVY), the PowerShares Nasdaq 100 Index (QQQ), and the iShares MSCI USA Minimum Volatility Index (USMV).  My reason for doing so is that I believe each also represents a “style” of investing that the market displays tendencies to favor at various times.

As is customary to all of my ETF models, I have built in rules that will protect investors during periods of protracted market declines.  As such, the model may hold cash or short-term bonds when there are no attractive opportunities available in the equity markets.

While the full details for the new model can be found on the models page, here is a look at the summary page.

Model Inception Date:12/31/2002Data as of 01/31/2017
Total Return:589.3%240.9%
Compound Annual Growth (CAGR):14.7%9.1%
Sharpe Ratio:0.900.44
MAR Ratio: 0.910.16
Correlation to benchmark:0.30
Volatility: 14.2% 18.8%
Maximum Drawdown:-16.3%-55.2%
Winning Period %:66.9%
Best Monthly Period:10.20%
Worst Monthly Period:-7.98%

For Charter subscribers, the new model is available at no additional cost.

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Model Rebalance

All Models have been rebalanced. Folio Investing clients should receive notice by email.  Subscribers can find the current holdings and commentary in the Members area.  The next scheduled rebalance is March 1, 2011.

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Model Rebalance…

All Models have been rebalanced. Folio Investing clients should receive notice by email.  Subscribers can find the current holdings and commentary in the Members area.  The next scheduled rebalance is February 1, 2011.

Read more

Model updates…

All Models have been rebalanced. Folio Investing clients should receive notice by email.  Subscribers can find the current holdings and commentary in the Members area.  The next scheduled rebalance is January 3, 2011.  

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