Research has shown that combining growth and value stocks in a portfolio enhances returns and reduces risk, but how to blend these styles effectively is not as clear. Should investors opt for a tilt in favour of value or growth, or should they try to make tactical shifts between styles as opportunity warrants?

Neither, suggests a recent study from New York-based Bernstein Investment Research & Management. Analysts there maintain that combining value and growth in a systematically rebalanced 50/50 allocation can deliver better returns than either a strategic tilt or a style-timing strategy alone — and with less risk.

Even investors who accept the wisdom of multi-style investing hold a common belief that value wins over time, and that a portfolio that has both value and growth stocks should tilt toward value. After all, for the past quarter of a century, value indices have tended to outperform growth indices by about 2% in annualized returns. But Bernstein’s research shows this is not so clear-cut.

First, the very method used to build the indices holds a subtle bias. To divide an index into growth and value subsets, analysts rank each stock on standard value measures (for example, price/book ratios), and define the lower-priced half of the overall index as “value” stocks and the higher-priced half as “growth.” In other words, growth stocks are defined in terms of their price as “not value” stocks.

But sheer expensiveness is not what most growth investors look for. They look for above-average rates of growth, especially in earnings, and if growth is sustainable.
Stocks meeting this definition generally are higher-priced than the norm, but higher price is not their defining feature, Bernstein maintains. It is possible for a low-priced stock to have good growth prospects. Bernstein suggests at least one-sixth of the market consists of such stocks and another sixth consists of expensive stocks with poor growth.

Yet “star” stocks with good growth that are trading inexpensively fall into the value group because they are cheap. The “duds” that have poor growth and are expensive get classified as growth because they are not cheap. This skews the performance of style indices, Bernstein says, as the stars outperformed the market by a full percentage point annually between 1981 and 2003, whereas the duds underperformed by 2.3 percentage points. In other words, value indices beat growth indices because the former tend to include stars and avoid duds.

For conservative investors concerned about volatility, there is even more to consider, Bernstein maintains. Growth and value stocks historically have been cyclical. Swings in performance are hard to endure emotionally and can adversely affect long-term returns.

Active value and growth managers also tend to outperform at different times. According to the Bernstein research, the premiums of active value and growth managers had a negative 0.21 correlation to each other from 1981 through 2003. But that cyclicality can be turned to advantage. Because the two styles are successful at different times, combining them in one portfolio can create a buffer against dramatic swings, reducing volatility and the subsequent drag on returns.

The study’s findings show the median combination of half active value and half active growth outperformed the market in 57% of the rolling three-year periods between 1981 and 2003 — more than either style alone. This increased to 62% for five-year periods and to 75% over 10-year periods. The combination provided equal exposure to opportunities in both domains and offset the risk of either style.

But what about switching periodically? Not only is tactical style- tilting risky, it’s also difficult, Bernstein maintains. Tilting between growth and value increases portfolio volatility, and the tilts have to reach 60/40 or even 70/30 to provide a significant increase in return. With so much riding on each bet, it’s critical to get the tilt of tactical bets exactly right and at the right time — a high standard to meet. IE