Styles
Now that you understand how portfolios are structured (strategies), you can explore how securities within those portfolios are selected. Investment style answers a different question: not "how much in each asset class?" but "what kind of securities do we pick?"
Active vs. Passive Management
The most fundamental style choice is whether to try to beat the market or simply match it.
| Feature | Active Management | Passive Management |
|---|---|---|
| Goal | Outperform a benchmark index | Replicate a benchmark index |
| How | Manager selects securities, times trades | Holds all (or a representative sample of) index securities |
| Fees | Higher (0.5%-2% annually) | Lower (0.03%-0.20% annually) |
| Turnover | Higher (frequent buying/selling) | Lower (trades only when index changes) |
| Tax efficiency | Lower (more realized gains) | Higher (fewer taxable events) |
| Foundation | Belief that skilled managers can find mispriced securities | Based on the Efficient Market Hypothesis (EMH): markets are efficient, so beating them consistently is unlikely |
Think of it this way: Active management is like hiring a personal chef who picks every ingredient. Passive management is like ordering a set menu that mirrors exactly what everyone else is eating. The chef costs more and might make a better meal, but statistically, the set menu wins more often over time.
Key takeaway: Over long periods, the majority of actively managed funds underperform their benchmark index after fees. This is the core argument for passive management.
Exam Tip: Gotchas
- Active management is not "better" or "worse." It depends on the market. Active managers have a better chance of outperforming in less efficient markets (small-cap, international, emerging) where information is harder to obtain. In highly efficient markets (large-cap U.S. stocks), passive strategies tend to win.
- Passive management is based on the Efficient Market Hypothesis (EMH), but that does not mean markets are perfectly efficient in all segments. Less efficient markets (small-cap, emerging) give active managers more opportunity.
Growth vs. Value Investing
These two styles represent opposite approaches to stock selection.
Growth Investing
- Focuses on companies with above-average earnings growth potential
- Typically higher price-to-earnings (P/E) and price-to-book (P/B) ratios (investors pay a premium for expected future growth)
- Companies often reinvest profits rather than pay dividends
- Higher volatility (growth expectations may not materialize)
- Examples: technology companies, innovative disruptors
Value Investing
- Focuses on stocks trading below their intrinsic value (low P/E, low P/B)
- Companies may be temporarily out of favor or overlooked by the market
- Built on the margin of safety concept: buying at a discount provides a buffer against error
- Tends to be less volatile than growth investing
- Examples: mature companies in established industries trading at discounts
| Feature | Growth | Value |
|---|---|---|
| Valuation | High P/E, high P/B | Low P/E, low P/B |
| Dividends | Low or none (reinvested) | Often higher |
| Volatility | Higher | Lower |
| Strategy | Pay a premium for future earnings | Buy at a discount to intrinsic value |
Exam Tip: Gotchas
- Growth stocks have higher P/E ratios because investors are paying for expected future earnings, not current earnings.
- Value investing requires patience. Undervalued stocks may stay undervalued for extended periods ("value traps").
Income vs. Capital Appreciation
These styles differ in what the investor prioritizes: current cash flow or long-term growth.
Income Investing
- Focuses on securities that generate regular income (dividends, interest payments)
- Typical holdings: bonds, preferred stock, dividend-paying stocks, REITs
- Suits investors who need current cash flow (e.g., retirees)
- Lower growth potential but more predictable returns
Capital Appreciation
- Focuses on long-term growth in the value of assets
- Accepts lower or no current income in exchange for higher future returns
- Typical holdings: growth stocks, small-cap stocks, emerging markets
- Suits investors with long time horizons who do not need current income
Exam Tip: Gotchas
- Income investing and value investing are NOT the same thing. Value investing looks for underpriced stocks (which may or may not pay dividends). Income investing specifically targets securities that generate regular cash flow regardless of whether they're undervalued.