As a model for asset allocation we use the example of a Core/Periphery strategy.  The basic thinking behind Core/Periphery is simply this: a large segment of your portfolio should reflect fairly stable, seldom-changing exposures to diversified traditional equities and fixed income asset classes.  This is the core component.  Then, with a smaller percentage of total holdings (so as not to put too much of your total assets at risk), you can identify more “exotic” exposures where you think returns may be particularly attractive over shorter cycles, and trade in and out of these positions more frequently as market conditions suggest.  By diversifying the asset classes contained in the periphery component you also hedge the risk that any one of your cyclical bets may prove way off the mark.

There is no one accepted split between core and periphery, but for purposes of this exercise let us seek to construct a portfolio with 85% core holdings and 15% periphery.  The first task is to build out the stable core.

The core should consist largely of traditional equities and fixed income holdings.  The percentage allocations to each asset class, as well as the extent to which the core should contain traditionally riskier assets like emerging markets equities or real estate investment trusts (REITs), depends on the investor’s risk profile (note: in a forthcoming posting we will be talking more about the formation of an investment policy for asset allocation based on investor risk objectives and risk tolerance).

Let’s assume here that the investor has a somewhat growth-oriented objective and a long-enough time horizon to justify the inclusion of some riskier assets.  We will thus start by determining the percentage split between equities and fixed income for the core component, which as we noted above is to be 85% of the total portfolio.  Of that 85%, equities will comprise 50% and fixed income will make up 35%.  Now, we could simply stop there and provide one broad equities and one broad fixed income exposure: say, the iShares Russell 3000 Stock Index (ticker IWV) and the iShares Barclays Aggregate Bond Index (ticker AGG) respectively.  Quite easily done.

However, we know from earlier discussions on style investing that there can be distinct benefits to segmenting exposures into style-specific asset classes.  For example, we might want to incorporate both valuation style (style versus growth) and capitalization style (large versus small).  A good selection here may be the iShares Russell 1000 Value Index (IWD) and the Russell 1000 Growth Index (IWF) for value-versus-growth exposure, and the Russell 2000 Index (IWM) to capture the small-cap component.  We have heard about the so-called “value effect” (see our June 24 post “A Practitioner’s Guide to Style Investing (3)” for a discussion about his phenomenon) and would like to strategically overweight this asset class.  Using this approach we may break down that 50% core equities component as follows: 25% large value (IWD), 15% large growth (IWF) and 10% small cap (IWM).

In this case our core portfolio is still limited to domestic US stocks, however, and we know that most of the growth in the world is taking place elsewhere.  We believe that a core exposure in non-US stocks is also warranted.  This should reflect both developed non-US markets, for example the MSCI EAFE – Europe, Australasia and Far East Index (ticker EFA) and the MSCI Emerging Markets Index (EMM).  Now our core equities exposure is more precisely defined along both style and geographic location lines.  Our 50% core equities component may now look like this: large value (IWD) 15%, large growth (IWF) 10%, small cap (IWM) 7.5%, developed non-US (EFA) 10%, and emerging markets (EMM) 7.5%.

Now we have to decide if we want to diversify the 35% core fixed income component away from the single broad-market exposure.  This depends on several factors: many investors see bonds as a safe haven rather than an active opportunity for increased returns.  Under this way of thinking it can be perfectly appropriate to leave that entire 35% in the broad Barclays Aggregate (AGG) holding.  But since we can diversify the fixed income component let’s see how that could work: for example, intermediate term US Treasuries (iShares Barclays 3-7 Year Treasury – ticker IEI), investment-grade corporate bonds (Barclays Intermediate Credit – ticker CIU), high yield bonds (iBoxx High Yield Corporate – ticker HYG), and non-US exposure (S&P/Citigroup International Treasury – ticker IGOV).  Let’s divide these as follows: intermediate Treasuries (IEI) 12.5%, investment-grade corporates (CIU) 12.5%, high yield (HYG) 5%, non-US bonds (IGOV) 5%.

So our total core portfolio now looks like this:

Core Equities:                           50%

of which

US Large Value                         15%

US Large Growth                       10%

US Small Cap                           7.5%

Non-US Developed                   10%

Non-US Emerging                    7.5%

Core Fixed Income                   35%

of which

Intermediate Treasuries          12.5%

Investment Grade Corporate   12.5%

High Yield                                   5%

Non-US Government                   5%

The final step is to select the 15% peripheral component.  Now, as we noted above this component is expected to change on a much more dynamic basis than the core component.  Here is where you can tap into your inner market pundit and see if your read of global macroeconomic, geopolitical and socio-cultural influences on markets is correct or not.  For example, you may have a view that the property and financial markets in Asia are set for a boom and want to be a part of that. You could take a position in the FTSE EPRA/NAREIT Developed Asia Global REIT Index (ticker IFAS) and the MSCI Far East Financials Sector (ticker FEFN).  But hold on, you think, that boom may not come to pass, so let’s at least hedge part of that exposure with a relatively uncorrelated asset like gold: iShares Comex Gold Trust (ticker IAU).  Equally weighting these three periphery assets lets us complete the portfolio:

Periphery Exposures:                15%

of which

Asia Global REITS                      5%

Far East Financials                       5%

Gold                                            5%

Voila!  You now have a diversified portfolio allocated along risk tolerance guidelines comprised of ETF exposures tracking well-known benchmark indexes.

Important disclosures: The above example is used for illustrative purposes only and does not represent a recommendation or solicitation by the author for this or any other specific asset allocation strategy.  Investors should carefully weigh their own return and risk considerations before investing in ETFs as well as heed the transaction costs, tax implications and other material factors.  Past performance is not a meaningful predictor of future returns.

In a sense ETFs are like mutual funds in that they are pooled vehicles containing multiple assets; in another sense they are like common stocks because they trade continually in the intraday market on securities exchanges. In another sense they are manifestly different from both mutual funds and stocks, and these differences matter from a research standpoint.

Not an actively managed mutual fund

With the exception of the index fund variety, most mutual funds tout the investment skills of the fund management team as one of the key selling points, and the point of having a team of ace professionals is to “beat the market”. Actively-managed funds will advertise how decisively they outperformed the S&P 500, or the Barclays Corporate/Government Bond Index, or the Nikkei 225 Japan Index. So clearly a big part of the research one conducts on such a mutual fund is on the fund managers themselves – what qualities and strategic mindset make it likely that they can consistently beat the market?

That is not a central feature of ETF research. Let’s consider for argument’s sake two contrasting vehicles: the iShares Russell 1000 Value Index (IWD) and the BlackRock Large Cap Value Fund (MDLVX). The Black Rock Large Cap Value Fund is an active fund managed by Robert Doll, a seasoned investor with a long track record of active fund management. If you invest in MDLVX you are in no small part investing in the skills of Doll and his team of portfolio managers and analysts. This team is fishing in the pool of large cap value stocks (i.e. the Russell 1000 Value Index) and taking positions in a relatively small number of those stocks deemed to be attractive by the metrics of their investment strategy. According to the investor factsheet for MDLVX the fund currently holds 107 stocks. For this expertise you are paying a management fee of 1.40%.

By contrast, the entire purpose of the exchange traded fund IWD is to replicate the Russell 1000 Value, not to beat it. When you look at the performance of IWD what you care about is how closely the performance of the ETF mirrors that of the benchmark. For example as of 6/30/10 the 1 year return of the Russell 1000 Value Index was 16.92%, and for IWD the return was 16.75% (and bear in mind that returns for ETFs, as for mutual funds, are generally presented net of fees). The 5 year return was likewise: -1.64% for the index and -1.73% for the fund. For this convenience in obtaining a proxy for a market benchmark you are paying 0.20% in management fees.

Interestingly iShares, one of the leading ETF firms and the operator of IWD among many others, was recently acquired by BlackRock from Barclays and now coexists alongside Bob Doll and his colleagues.

The benchmark is what matters

Since with an ETF you are effectively buying the underlying benchmark, what matters is how well you understand the benchmark, and this really is where the research focuses attention. Benchmarks can be as broad or as narrow as you wish – for example “the whole US stock market” (something like the Russell 3000 Index is a good proxy) or “the engines of global growth” (there is an ETF that tracks the MSCI BRIC Index of Brazil, Russia, India and China). As you get into the exercise of researching and understanding the performance of different benchmarks you will start to think about how they relate to your own investment objectives – how much return you are seeking over defined time periods and what kind of risk you feel comfortable assuming along the way. This is the beginning of understanding the art and science of asset allocation. As I noted earlier in this post, ETFs can be an efficient and effective tool for asset allocation, and this will be a topic for one of our posts in the very near future.

This is a guest post written by Anthony Privetera*

The severe downturn of the financial markets that began in 2007 has led many investors to question their investment strategies and the choices they made in the past.  Investment decisions are among the most important life choices a person can make. They may determine where your children will be able to go to college, when you’ll be able to retire and the type of lifestyle you’ll enjoy after you retire.

1. What is an ETF?

Exchange-traded funds are a type of pooled investment vehicle, meaning a single tradable entity containing multiple assets of one or more category such as stocks, bonds, commodities or currencies.  ETFs were originally designed specifically to track a specific market benchmark, like the S&P 500 or the Barclays Aggregate US Bond index.  In this way ETFs have much in common with the mutual fund variety known as index funds.  Like index funds, ETFs are “passive” investment vehicles – their purpose is to closely replicate the performance of a market benchmark, not to outperform the benchmark (this is what actively-managed mutual funds attempt to do).

2. How do ETFs trade?

ETFs trade like regular shares of common stock, which is to say on a stock exchange with prices changing continually throughout the trading day in response to buy and sell orders.  For example you can go to any popular financial news site, like Yahoo! or Wall Street Journal Online, type in the ticker symbol EPP (iShares MSCI Pacific ex-Japan Index ETF) and see its current share price ($37.85 as of 1.58pm on July 8), time of last trade, transaction volume, 52-week high/low, P/E ratio etc. – all the metrics you see for any ordinary share of stock.

This is convenient for ETF research and trading, and is quite different from the way mutual funds trade.  Mutual funds typically price once at the end of each trading day, and investors buy and sell (“redeem” in mutual fund parlance) based on the Net Asset Value reflected in that price.

3. How do fees and expenses differ between ETFs and mutual funds?

Mutual funds often come in several varieties of share class, for example: front-end or back-end load, retirement, institutional and so forth.  Each class reflects different types and levels of fees, including sales load, redemption, 12b-1 and other varieties (for a detailed examination of mutual fund fee structures please refer to David Buchanan’s excellent series “Understanding the various forms of mutual fund fees”).

ETFs typically contain just management fees (and occasionally other fund operating expenses).  Because they are passively-managed vehicles ETFs will generally have lower management fees than actively managed mutual funds.  In fact, according to a study produced by the ETF company iShares, ETF management fees are considerably lower on average than those for passively-managed index funds as well.  For example (according to this study) the average management fee for active large cap blend mutual funds is 1.11%, and 0.42% for index funds in this style space.  By comparison the management fee for the iShares S&P 500 Index fund (ticker IVV) is 0.09%, and for the Russell 1000 Index fund (ticker IWB) is 0.15%.

4. What asset classes can I gain access to through ETFs?

The number of asset classes covered by ETFs increases every day, and your ETF research will no doubt show you a range of  both broadly-and narrowly-defined exposures.  You can buy an ETF reflecting the market for US large cap value stocks (Russell 1000 Value index), or the Chilean stock market (MSCI Chile index), or the 7-10 year US Treasury bond market (Barclays 7-10 Year Treasury index), or specialized commodities positions from crude oil to gold.  This makes ETFs a very handy instrument for portfolio construction, as it is possible to obtain very precise return, risk and correlation goals through selection of the appropriate assets.  Moreover, because ETFs have a low tracking error relative to the benchmark, performance will be more directly related to asset class performance as opposed to fund manager decisions that are part and parcel of actively managed funds.

5. Are ETFs the same as ETNs?

ETNs are Exchange-Traded Notes, and they are not the same as ETFs.  ETNs are a variety of a complex type of asset known as structured products.  Structured products are essentially comprised of bonds issued by an AAA-rated financial institution containing one or more options or other derivative instruments like swaps.  ETNs are often used to obtain exposure to even more exotic asset classes than ETFs, for example a commodity like copper or liquid natural gas, or a frontier stock market like Indonesia.  It is a good idea to approach these instruments with caution, as they come with certain risks that are not features of ETFs.

As with any investment, you want to make sure you have conducted your ETF research thoroughly before wading into the ETF pool.  A good rule of thumb is to focus your ETF research on ETF fund families that have been around for awhile and grown with the market, like iShares, PowerShares or SSGA’s SPDR fund family.  Also remember that while ETFs can take you all over the world in terms of obtaining asset class exposure, they won’t shield you from the risk of investing in volatile markets.  You can find fact sheets about each ETF offered by any of the fund families, including return and risk metrics, fund holdings and other important information.

Be on the lookout for more blog postings on ETFs in the coming weeks, as we will be discussing various aspects of these instruments and strategies for their use.

Note from Jemstep team: Jemstep will be releasing its ETF product in the very near future.

Don’t obsess over the short term (i.e. tune out CNBC)

I mean no offense to that particular network – this advice applies equally to all so-called “financial news” networks.  Always remember that their real purpose for being revolves around entertainment, not thoughtful investment advice.  One of the most egregiously awful phrases in the English language is comprised of these words: “The market closed up (or down) today because of X”.  X is home prices or unemployment numbers or the IPO of XYZ Company, always accompanied by the stock photos of homes with foreclosure signs, long queues outside the unemployment benefits office, or XYZ Company employees popping Champagne corks.  In reality there is no X.  There are billions of Xs – X factors really – which interact in complex ways and shape what the market does on any given day.  More than 99% of the time there is literally no correlation between any single event and the movement of the stock market.

The larger point to make here is that the short term is essentially unknowable.  The financial news shows like to focus on the short term because it offers more drama – CNBC even features a “Halftime Report” in the middle of the day to give securities trading the look and feel of a sporting event.  That is no doubt catchy from an entertainment point of view, but it is not going to help you make better investment decisions.

Measure risk, not just return

When it comes to investment analysis, risk and return are two sides of the same coin.  Too often we forget that to properly measure the performance of our assets and portfolios we have to take into account, not just what they earned but also how much risk we assumed in getting that return.  For a thorough discussion on alternative methodologies for measuring risk please see Kevin Cimring’s excellent posting of June 7 “Measurement of risk in mutual fund research”.

Risk matters for two principal reasons.  First, it relates to your capacity to assume large short-term losses given your available financial means, time horizon, specific liquidity events and so forth.  An asset that produces an expected 25% annual return over 5 years may not be a great investment if its average annual volatility – for example as measured by standard deviation – is also 25% and you will be needing the money two years from now to pay for your kid’s college education.

Apart from your capacity to assume risk you also need to consider your propensity to endure the kind of stomach-churning volatility you see in those short-term daily price moves the perky anchors at CNBC are babbling about.  Propensity has more to do with emotion than with financial means.  Some people are better at keeping their emotions in check than others and can resist succumbing to the fear and greed that lead to bad investment decisions.

Diversify, diversify, diversify

Think of this third recommendation as the Golden Rule of Investing: your chances for long-term investing success are much higher when your portfolio is properly diversified.  To be diversified means to have a combination of assets in a portfolio which behave in different ways from each other.  My investment advice is to start with the broad investment categories: equities, fixed income and alternative assets (things like commodities, real estate, currencies and hedge strategies).  Within a single investment category (such as equities) diversification can mean having different asset classes (domestic stocks, foreign stocks, value, growth, large or small cap etc.).  Within a single asset class it can mean having 20-25 different names representing different industry sectors to reduce non-systematic risk.

Diversification may seem suboptimal in the short run.  If the stock market goes on a bull tear then a portfolio containing bonds and other things probably will not do as well as one hardwired to an equities index.  But over the long run the economy will probably go through periods of inflation, deflation, growth, recession, euphoria and manic depression.  Diversified portfolios will survive these twists and turns better than those which are more directly vulnerable to the threats each different market cycle brings.

No one single strategy is guaranteed to be a surefire success, especially in the kind of volatile market conditions we have today with a very high level of uncertainty about the economy’s long-term direction.  However, following these three principles of investment advice should put you on firmer ground for weathering the storm and emerging intact in calmer seas.

For many decades now the conventional wisdom about investment decision-making has rested on the foundation of rationality.  In this world (one comprised primarily of theoretical economists in their academic institutions) human beings possess complete, perfect knowledge about all possible current and future outcomes of any decision, and thus always make the ones that maximize their economic value.  Among economists this is traditionally known as Rational Man Theory.  In the world of investing Rational Man extends into a comprehensive theory for how markets work called the Efficient Markets Hypothesis (EMH).  EMH states that, in addition to investors being the omniscient actors of the Rational Man Theory, markets themselves function perfectly and without friction.  Prices adjust instantaneously to information as it becomes known, with the rational investors buying and selling based on complete knowledge about every single piece of information that could influence the value of every tradable asset.

How does this tale of Rational Man and EMH relate to the value effect?  Well, according to the principles of EMH there cannot be a value effect.  Everything material to a stock’s price is acted on within nanoseconds of becoming known, so prices follow a random walk up and down as each bit of data blips across the airwaves.  There cannot be a systemic long-term advantage to investing in stocks with certain characteristics, like the low Price-to-Book attributes common to value stocks, because such an advantage would be immediately acted upon by rational investors and thus disappear – in finance-speak they would be “arbitraged away”.

Yet study after study upholds compelling evidence that the value effect exists, upending the wisdom that has held sway among financial practitioners for so many years.  What gives?  Enter the second character in our drama, Behavioral Woman.

Most people would look at the assumptions of rational economics and instinctively feel that they are off the mark as an explanation for how real humans make decisions.  We’re not rational, we are quirky and most of the time cannot even clearly define what “value” actually means to us, let alone maximize it every time we make a decision.  But as intuitive as that reasoning is, for a long time it was hard to turn Behavioral Woman into a well-reasoned explanatory theory about investing that could challenge Rational Man.

That started to change in the late 1970s and early 1980s with the research of two psychologists, Daniel Kahneman and Amos Tversky.  Kahneman and Tversky methodically studied the way actual people go about making decisions and in so doing pioneered the discipline of behavioral economics (for which Kahneman won the 2002 Nobel Prize in Economics, Tversky having passed away some years before).  Behavioral economics is a topic in and of itself (and probably deserves its own blog posting somewhere down the line) and with each increasingly intense and seemingly irrational boom-and-bust cycle we have witnessed over the past 15 years its adherents have grown in number.

The main point to make for purposes of this discussion is that many of the “errors” people commit when making economic decisions (read: making dumb choices) are not random but actually consistent and predictable.  Kahneman and Tversky called these “heuristic errors” – think of these as shortcuts hardwired into the human brain that consistently trip up our best intentions to make smart decisions.

So how might Behavioral Woman offer us some insight into why the value effect exists?  Well, by their very definition value stocks are underpriced companies that for some reason or other seem to be ignored by the market.  There’s no “sexy story” about the typical value stock – it is the wallflower at the dance ignored by prospective suitors.  The sex appeal in the world of investing usually falls to the growth stocks – think of the theatrical wizardry of Steve Jobs as he launches another worldbeating new technology, or the youthful exuberance of Google’s management team, or any shiny, new thing promising to revolutionize everything that matters in the world.

Sex appeal probably should have nothing to do with making smart financial choices – but actual human behavior tells us differently. Some Kahneman-Tversky acolyte may tell Behavioral Woman at a cocktail party that value stocks return more money than growth stocks over the long run, but her brain is just waiting to hear that loudmouthed guy swilling a gin & tonic boast about how he just “got in” on the newest thing that’s going to change the world forever.  She should patiently invest in a value portfolio to get the best return over her time horizon, but her brain activates the shortcut trigger, panics that missing this hot growth stock will be losing the opportunity of a lifetime, and makes a decision more likely to result in tears than triumph.

The debate rages on – despite its many apparent flaws, rational economics has been in the mainstream of both theory and practice for too long to simply vanish from the public discourse.  Meanwhile we still have the value effect, we know a lot more about the behavioral aspects of investing than we used to, and there are plenty of opportunities to use that knowledge…well…rationally!

• Government or Treasury bonds are composed primarily of Treasury securities (government debt). The risk associated with government bonds depends on the stability of the country issuing them. Bonds issued by stable countries, such as the U.S. or the UK, are very highly rated, while bonds issued by economically emerging nations are typically considered more risky. Interest on U.S. Treasury bonds is typically exempt from state and local income tax.

• Government-insured mortgage-backed bonds are made up of home mortgages insured by Fannie Mae and Freddie Mac, which are government-sponsored enterprises. As a result, these bonds are generally considered to be low-risk.

• Municipal bonds issued by state and local governments and agencies are attractive to investors in upper tax brackets, since the interest is exempt from federal income tax. These funds may buy only bonds issued within a specific state, or they may invest regionally or nationally. It can be advantageous to invest a fund focusing on municipal bonds in the state where you live, since the interest is likely to be exempt from state and local tax as well.

• Corporate bonds are issued by companies wanting to raise capital and are guaranteed by the issuing company. The risk lies in the company’s ability to continue paying interest and return the investor’s principal at maturity. The bonds of a larger established company with a strong balance sheet are generally less risky (but may also pay less) than those of a struggling business.

• A diversified bond fund invests in a range of bond types including government, municipal, and corporate.

Bond funds are not risk free

Its important to understand that bonds aren’t risk free. In conducting your mutual fund analysis, you should know that rising interest rates can impact the value of your bond holding. Interest rates are currently hovering at their lowest levels in decades, so you should be aware that just as bond prices go up when yields go down, the prices of bonds will generally drop as yields—interest rates—go up. Bonds with a longer maturity are impacted more by an upward increase in interest rates than shorter term bonds. A ten year bond will usually lose more of its value if rates go up than a two year bond.

Which bond funds to invest in depends on many factors, including the State you live in, as well as your overall objectives and asset allocation. This is something we’ll explore further in future posts.

There are two types of handbag shoppers in the world (okay, there are many more than that, but two will suffice for this illustration). One is the intrepid bargain-hunter who searches high and low for something of high quality and a low price relative to that quality. You’ll find her in Filene’s Basement or nondescript boutiques with racks and bins of bags of various (sometimes dubious) levels of quality, rubbing leather straps with her fingers, holding a bag up at 15 different angles to examine the stitching, turning it inside out to parse the details of the interior applications, rejecting 20 candidates before settling on one. Given an opportunity to do a little price bargaining with the shopkeeper she will do that too.

That type, in short, is a value investor.

Exhibit B: This shopper can be found in the ritzy, high-end stores that line the streets of Beverly Hills, New York’s Upper East Side or London’s Knightsbridge. But she’s not just a wannabee brand-a-holic for whom any old Coach or Fendi or Kate Spade will do. She has (or thinks she has) a keen sense of what the “must-have” bag of the next season is going to be, and she wants that bag at any price because it can only become more valuable as it becomes ever more feverishly sought-after.

Therein lies the archetypal growth investor.

Value and growth investing are simply two different philosophies driving strategies for profitable investing. A value investor starts by creating a universe of stocks perceived to be undervalued relative to the market. The “Price-Book threshold screen” we mentioned earlier is one way to accomplish this: start with all stocks whose price per share is low relative to reported book value per share. Book value is what is left on the company’s balance sheets when liabilities are subtracted from assets.

The next tool in the value investor’s arsenal is a mechanism for picking out from this universe stocks that are worth more than their sticker price as opposed to the ones whose low valuations simply reflect low quality. One school of value investor is the “fundamentalist” who combs over every detail of a company’s financial statements, business strategy, pending sales contracts and anything else he can get his hands on to assess whether its fair value is lower than the market value indicated by the stock price. Here’s where something like “normalized Free Cash Flows” come into play: the value investor creates a model with assumptions sustainable cash flows, figures out what those cash flows represent in present value terms, and compares that result to the current share price to determine whether a value play exists.

A variation of the fundamentalist is the deep-value investor who applies similar techniques but has a predilection for really distressed situations where the market seems to have written off the stock. The deep-value type believes that not all distressed situations are lost causes and hopes to snap up the survivors at pennies on the dollar. Finally, a third distinct type of value investor is the contrarian, whose world view can largely be summed up as “the conventional wisdom is wrong and I am right”. If the herd is running in one direction the contrarian is off by herself looking for overlooked opportunities.

The mentality of the growth investor is quite different. Just like the shopper in her quest for the “it” bag, the growth investor’s perpetual dream is to spot the next Apple or Google before anyone else does, in which case it is likely that the price you actually pay won’t really matter all that much relative to the rewards you will enjoy. Of course there has to be some kind of a quantitative discipline to spot these opportunities. Price/Earnings to Growth (PEG) is one metric beloved of many growth investors. PEG says that a stock’s P/E ratio, itself a measure of how cheap or expensive a stock is compared to its peers, is more meaningful in the context of its prospects for earnings growth. A stock with a P/E of 20 may be considered expensive if the average P/E for the market is 15, but if the stock has a 5-year consensus earnings forecast of 15% annual growth and the average market growth is expected to be 3% then the growth investor would argue it makes sense to buy the stock.

A variation of growth is Growth at a Reasonable Price (GARP), which tries to combine some value investing techniques into a growth model. In our world of handbag shoppers the GARP investor hopes to find one of those hot-ticket bags from a store offering temporary promotional discounts.

How do the numbers stack up for growth and value? Below we reproduce the chart we introduced last week showing multi-period total returns for different styles as measured by the Russell indexes.

The Russell 3000 is a broad-cap index and so provides a more distinct comparison of value and growth. Over a 16 year period to 2010 the Russell 3000 Value Index outperformed its growth counterpart by a bit under 2% on an average annual basis. For the ten year period the difference was greater – you earned almost 7% more (annually) from choosing value over growth. On the other hand the value index was much worse than the growth index for the three year measure. This is largely because the value index contains a disproportionate number of financial services stocks, which were all hit hard by the Wall Street meltdown in 2008.

Longer time horizons tend to be a more accurate gauge of value differences as they reflect multiple market cycles. The outperformance indicated here by value stocks over the long term is not anomalous: extensive studies by academics and market practitioners over time have demonstrated fairly compelling evidence that on average value stocks tend to outperform growth stocks over long periods of time. That is on its face surprising: if you can earn 2% or more in average annual returns over time from investing in value stocks then why wouldn’t everyone do so? And if that much value is really being left on the table then why wouldn’t it be “arbitraged away” in the parlance of financial markets? Aren’t markets supposed to be rational? These are all important questions, and we will be coming back to them in the next post.