There are six major investment styles i.e. active vs passive management, growth vs value investing and small-cap vs large-cap companies. I am going to explain each of these styles together with a bonus style known as momentum investing. It is important to understand the investment style of a fund, a fund manager or any other professional who is managing your investments. It is equally important to understand your own investment style if you are a self-investor. That’s because it will help you to understand better which shares or funds to focus your attention on.
Active or Passive Management
In determining investment style, an investor should first consider the degree to which they believe that financial experts can create greater than normal returns.
Investors who want to have professional money managers carefully select their holdings will be interested in active management. Actively managed funds typically have a full-time staff of financial researchers and portfolio managers who are constantly seeking to gain larger returns for investors. Since investors must pay for the expertise of this staff, actively managed funds typically charge higher expenses than passively managed funds.
Some investors doubt the abilities of active managers in their quest for outsized returns. This position rests primarily on empirical research which shows that, over the long run, many passive funds earn better returns for their investors than do similar actively managed funds.* Passively managed funds have a built-in advantage—since they do not require researchers, fund expenses are often very low.
Growth or Value Investing
The next question investors must consider is whether they prefer to invest in fast-growing companies or underpriced industry leaders. To determine which category a company belongs to, analysts look at a set of financial metrics and use judgement to determine which label fits best.
The growth style of investing looks for companies that have high earnings growth rates, high return on equity, high-profit margins and low or zero dividends yields. The idea is that if a company has all of these characteristics, it is often an innovator in its field and making lots of money. It is thus growing very quickly, and reinvesting most or all of its earnings to fuel continued growth in the future.
The value style of investing is focused on buying a strong company at a good price. Thus, analysts look for a low price to earnings ratio, low price to sales ratio, and generally a higher dividend yield. The main ratios for the value style show how this style is very concerned about the price at which investors buy in.
Momentum investing is a system of buying stocks or other securities that have had high returns over the past three to twelve months and selling those that have had poor returns over the same period.
Small Cap or Large Cap Companies
The final question for investors relates to their preference for investing in either small or large companies. The measurement of a company’s size is called ” market capitalisation” or “cap” for short. Market capitalisation is the number of shares of stock a company has outstanding, multiplied by the share price.
Some investors feel that small cap companies should be able to deliver better returns because they have greater opportunities for growth and are more agile. However, the potential for greater returns in small caps comes with greater risk. Among other things, smaller firms have fewer resources and often have less diversified business lines. Share prices can vary much more widely, causing large gains or large losses. Thus, investors must be comfortable with taking on this additional level of risk if they want to tap into a potential for greater returns.
More risk-averse investors may find greater comfort in more dependable large cap stocks. Amongst the names of large caps, you will find many common names, such as Amazon, Microsoft, and Facebook. These firms have been around for a while, and have become the elephants in their industries. These companies may be unable to grow as quickly since they are already so large. However, they also aren’t likely to go out of business without warning. From large caps, investors can expect lower returns than with small caps, but less risk, as well.
So understanding your own investment style or that of the fund, the fund manager or any other professional who is managing your investments is clearly important in helping you to monitor your investments even better.** You know it makes sense.
*Board of Governors of the Federal Reserve System. “The Shift from Active to Passive Investing: Potential Risks to Financial Stability?” Accessed June 1, 2020.
**The value of your investment can fall as well as rise and is not guaranteed, so you could get back less than you invested. Past performance is not a reliable indicator of future results. The contents of this blog are for information purposes only and do not constitute individual advice. You should always seek professional advice from a specialist. All information contained in this article is based on our current understanding of taxation, legislation and regulations in the current tax year. Any levels and bases of and reliefs from taxation are subject to change. Tax treatment is based on individual circumstances and may be subject to change in the future.