Investment style

Two equity funds can hold the same asset class and behave nothing alike.

The investment style is the reason. It is the approach the manager takes to choosing securities once the mandate is fixed. The mandate says what the fund may buy. The style says what the manager actually looks for.

The workbook gives one example on each side of the market.

In debt, a manager may select securities with certain credit qualities, or with a particular interest rate sensitivity. Both are deliberate choices, and both change how the fund behaves when conditions move.

In equity, a fund may choose mid-cap securities, which the workbook says generate better returns when markets are in momentum, but also see a greater fall when markets decline.

Style is one of three things that decide a fund's risk and return. The other two are the investment objective and the strategy.

Where style sits. Section 5.5 lists four factors that determine how a managed portfolio performs, and style is the third:

1. The investment objective, which fixes the asset class. A growth fund invests in equity; an income fund invests primarily in debt securities.
2. The strategy — active or passive; and within active, aggressive or conservative. A concentrated portfolio is the aggressive case, because each holding is large and one poor performer moves the whole fund. A well diversified portfolio is the conservative case.
3. The investment style of the portfolio or fund manager.
4. The resulting risk and return, which follow from the three choices above.

What a style actually selects on. The workbook's two illustrations are the ones to quote.

Chapter 2 adds that equity mutual funds offer a wide variety of schemes focusing on different market segments such as large, mid or small cap, sectors, strategies and investment styles for investors to choose from. So style is a shelf a retail investor picks from, not only an internal choice.

Why it matters for comparison. Section 5.5.2 says a peer group comparison is sound for funds following similar strategies and styles of investing. Style is therefore the filter you apply before ranking funds, not a footnote afterwards. Two mid-cap funds are comparable. A mid-cap fund and a large-cap fund are not, however similar their category labels look.

The workbook names no single best style, and gives no figure attaching to any of them. What it gives instead is a consequence: a style that shines in one market condition will lag in another, which is why it has to be identified before performance is judged.

Three debt funds, all holding only debt, all with a different style.

Illustrative portfolios, built on the two style dimensions the workbook names.

All three are debt funds. Pick the wrong one for the job and the mandate will not save you: a retiree who wanted stability and bought Fund Q gets a large gain when rates fall and an equally large loss when they rise.

Now the equity side, using the workbook's own example. Mr Bhatt holds Rs 5,00,000 in a mid-cap fund. Markets run up strongly and his holding grows to Rs 6,50,000 — the momentum advantage the workbook describes. The next year markets decline; the same style means he sees a greater fall than a large-cap fund would have delivered, and the holding drops to Rs 4,80,000.

His adviser's error was not fund selection. It was comparing that mid-cap fund against large-cap peers in the good year and concluding the manager was exceptional. The extra return came from the style, not from the skill — which is precisely why the workbook makes style a condition of a fair peer comparison.

Chapter 5, section 5.5 (Evaluating Performance of a Managed Portfolio), names the investment style as one of the determinants of a fund's risk and return, with the debt and equity examples. Section 5.5.2 then makes similar styles a condition of a valid peer group comparison. Chapter 2, section 2.10 mentions investment styles among the ways equity mutual fund schemes are differentiated.

The workbook's own sample question is the one to prepare: the risk and return in a fund can be explained by — the asset class, the investment strategy and the investment style, so the answer is all of them. Expect also a question separating strategy (active or passive, concentrated or diversified) from style (what the manager selects on), since the two words are used precisely and differently.

• Style is not strategy. Strategy is active versus passive, and aggressive versus conservative; style is what the manager selects on within that. The workbook lists them as separate factors and the distinction is examined.
• Style is not the investment objective either. The objective fixes the asset class; the style operates inside it. Two funds with the same objective can have opposite styles.
• A concentrated portfolio is an aggressive strategy, not a style. The workbook classifies it under strategy, with the reason: high exposure per security means one poor performer hurts the whole fund.
• Mid-cap is the workbook's equity example, and it cuts both ways — better returns in momentum markets, greater falls in declines. An answer that mentions only the upside is incomplete.
• Credit quality and interest rate sensitivity are the two debt style dimensions the workbook names. Do not import equity style labels into a debt fund question.
• Style is a precondition for comparison, not a result of it. Rank funds only after establishing that their strategies and styles are similar.
• This is the umbrella term. A specific named approach such as the value investment style is one style within it, and the workbook for this paper does not define the individual named styles.