4. Style Investing and Style Arbitrage - The view from Sabre
The Value and Growth debate has been raging for over 60 years - ever since Graham and Dodd introduced the concept of Value investing and T. Rowe Price disputed its merit and recommended Growth.
The market has since segmented accordingly into Value and Growth management styles. Each represents an investment philosophy - aiming to exclude the other style.
We do not subscribe to this view. We do not think that Value and Growth are mutually exclusive. This is because there are stocks which are both Value and Growth and there are those which are neither. We find that contrary to popular opinion both styles have positive alpha in the long term, i.e. as a buy and hold strategy over ten or more years.
There is a strong causal relationship between economic cycle and the style cycle. Good value stocks tend to do well when risk appetite is low, for instance when there is perceived uncertainty regarding future economic growth prospects.
Strong growth stocks tend to do well when the future looks bright and the present is good. Because economic variables are cyclical, style variables are also cyclical. In addition, behavioural reasons such as active managers "herding" (lead by emotions of fear and greed) exacerbate cycles and trends in styles. This has lead towards the existence of style rotation strategies.
The existence of style cycles and trends implies that style returns are reasonably predictable.
Style Arbitrage is a natural extension of Style Investing/Style Rotation to the long/short market neutral framework. In the long only framework investing for Value means being long Value stocks and measuring this portfolio performance against the index of all stocks
In the long-short framework this extends to Value Arbitrage - this means being long Value stocks and being short Non Value stocks. Similarly, investing for Growth extends to Growth Arbitrage.
Focusing on both the long and the short side doubles the cycles and the trends that exist for long investors. As a consequence predictability is improved which enables more confident forecasting of style rotation.
In addition to Value and Growth our process uses two more styles which have proven to have a strong causal and empirical relationship with stock returns -Momentum and Quality.
Each of our four major styles is represented by a number of subsidiary style factor mimicking portfolios. To capture which themes are 'fashionable', we have developed a regime-switching model for each style factor. The switch is turned on when we expect the factor to work and is turned off when we expect the factor not to work.
In addition, the relative importance of the performing factors is allowed to vary over time. Because each style factor is a real portfolio we know exactly what stock positions correspond to any combination of factors.
Style Arbitrage benefits from doubling of both long-term and short-term style investment opportunities. In order to prevent the adverse effect of a style going out of fashion in the market, Style Arbitrage employs regime-switching techniques for each style factor.
Sabre Fund Management manages the Sabre Style Arbitrage Fund. These views reflect the opinion of the manager for the purposes of educating qualified or sophisticated investors only and do not constitute an offer or solicitation to invest in the fund.
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