Copyright 1999 Maclean Hunter Publishing Ltd. The following article first appeared in the May 1999 edition of BENEFITS CANADA magazine.

Style matters

The equity style strategy is more important to a
plan's return than its asset allocation.


Investment style has always made a difference when it comes to returns, but few seem to know it. When it comes to the Canadian equity markets, institutional investors need to realize that in addition to searching for risk adjusted returns, they also need to vary how these assets are managed in order to successfully fulfil the pension promise.

By all measures, Canadian investors have lagged behind the U.S. in recognizing the significance of investment style. Many are familiar with the statistic that 85% of the variance in pension fund returns can be attributed to asset mix. The same goes for style allocation in Canadian equity portfolios: 85% of returns can be attributed directly to management style.


Investments can be handled in two broad styles: value and growth. In practice, there are really four categories: large cap growth, large cap value, small cap growth and small cap value.

Value managers rotate industries while shopping for value any place they can find it. They will hold industries and companies that are out of favour in the market, if they think that there is measurable value. They assume the price will rebound because of underlying fundamentals.

Admittedly, it is not as glamorous to invest in ignored companies or those that have not fulfilled their potential--but it works. In fact, in Canada, it is a steady and consistent way to beat the market.

Promoting and promising earnings expectations are highly discounted by Canadian investors and in times of uncertainty (and there have been many), Canadians come back to value. Value managers, waiting for their price target, are associated with lower portfolio turnover.

A definition of value excludes companies in which there is a definite recognized management competency issue, or where there are cash flow concerns. Value portfolios are chosen on fundamental ratios, such as:

bulletlow price-to-book;
bulletlow price-earnings; and
bullethigh dividend yield.

Growth managers, on the other hand, are harder to define. They focus on possible future earnings--up to five years into the future--or on success factors such as momentum (that is, what goes up is expected to go up again). These characteristics are associated with higher portfolio turnover, often exceeding 100% per year.


Theory says that value managers should do well in most down markets and underperform in strong bull markets. This is not the case in the large cap Canadian market. Value has outperformed in good times and in bad. In Canada, value style beat growth style in 13 of the past 17 years.

The BARRA Canadian Large Cap Value index has outperformed the Toronto Stock Exchange (TSE) 300 composite index by 2.7% a year since 1982. By comparison, in the U.S. over the full market cycle, value and growth styles performed about the same. Therefore, in the U.S., it is sensible for sponsors to be style neutral over the longer term.

If one simply observes the number of quarters or months in Canada where value outperforms growth, it is a small majority (see "The value in large caps," page 63). In the big picture, however, the sheer magnitude of value fluctuation proves that value outperforms growth. Notice the value "rebound effect" following a quarter of growth outperformance.

Value outperforms in the subsequent quarter by 3% greater than it outperforms in the average quarter. On the other hand, there is no growth style rebound in Canada.


Small cap equity is itself a separate asset class decision within equities that a number of pension plans take advantage of in Canada and in the U.S.

The performance of value may dominate growth when it comes to large cap stocks, but the opposite is true for small cap stocks. Small cap growth stocks outperformed small cap value stocks by 2% a year over the data series available from mid-1990 to 1998 (see "Growing small caps," page 65). In fact, small cap growth stocks outperformed the TSE 300 over roughly the past eight years, by 0.75% each year.

From mid-1990 through to 1997 Canadian small cap stocks outperformed the TSE 300, as the theory suggests. This past year, however, showed a tremendous decline in small cap performance. This premium should be recouped in the next few years if the theory holds true.

Over the last five years, the Canadian small cap sector has transformed, developing growth characteristics. Within the small cap universe by sector, the consumer and industrial sectors now represent 57% of the total, compared to 42% five years ago. This displaced the resource sector, which has diminished to 26% from 33%. Interest-sensitive stocks make up 41% of the TSE 300, while small cap stocks represent only 17%.

While small cap growth has outperformed small cap value by 2% a year over time, there are visible cycles in Canada to small cap growth and small cap value outperformance. Notice three cycles in the accompanying diagram:

bulletsmall cap growth cycle from the third quarter of 1991 through to mid-1993;
bulletsmall cap value cycle from the third quarter of 1993 through to the third quarter 1995; and
bulletsmall cap value cycle from the last quarter of 1996 through to mid-1998.


Contrary to conventional wisdom, in Canada the ScotiaMcLeod Median Bond index has outperformed the TSE 300 by 3% annualized since the beginning of 1982. Comparatively, value stocks have outperformed growth stocks by about 5% a year. Now, going back to the long-standing adage that 85% of a fund's success can be attributed to its asset mix, then a portfolio's style mix is just as critical to the fund.

Looking just at this decade through 1998, however, bonds and equities had equal returns. Within equities, on the other hand, value stocks outperformed growth stocks by about the same 5% annualized level. In retrospect, by returns alone, having a pure value manager would have been as important as getting the asset mix between stocks and bonds right.

Style allocation is always driven by returns. Even a small tilt towards the value style has historically improved a plan's return in its equity asset class. If we assume even half of the consistent historical outperformance in the future, this is still substantial.

The style decision has been a pivotal explanation of whether or not a plan's equity strategy has outperformed the TSE 300. By not consciously designing an equity strategy, the plan could very well have had TSE 300 characteristics and market-like performance. A growth style tilt requires that the investment manager distinguish himself by consistently adding 2.5% a year through stock picking. This is consistent with the belief that in Canada the growth style can only be successful if based on the stock-picking skill of the portfolio manager, while the value style can be, systematically, a stronger style.

The plan sponsor must select a manager who actually holds a portfolio corresponding to the plan's chosen equity strategy. A through investment policy will go a long way towards keeping managers on track. Style mix is the fiduciary's responsibility. If its investment managers gravitate to the weaker performing style over the mandate period, the sponsor is still responsible for the results.

Sam Wiseman was vice-president and portfolio manager at the former Bolton Tremblay Inc., in Toronto when this piece was written.