The strategy has a significant advantage over simply indexing the Russell 1000 or 2000 over the long run (Figure 3). An initial $1.00 invested in the strategy in February 1988 would have growth to $10.20 by October 31, 2007 while the Russell 1000 would have grown to $9.21 and the Russell 2000 to $8.12.
This strategy is easily implemented using iShares' Russell 1000 Index Fund (IWB) and iShares' Russell 2000 Index Fund (IWM). Both funds have small expense ratios of 0.15% and 0.20%, respectively, and small tracking errors relative to their underlying indexes.
Growth Versus Value Stocks
A similar alpha strategy is possible with growth and value stocks because they, too, have sustained periods of above- and below-average returns. Again, these differences are due to their specific characteristics and the desirability of holding one rather than the other over a cycle.
Growth stocks are typically desired for their above-average earnings growth, high profit margins and superior return on equity. Growth investors expect that a sustained period of above-average earnings growth will afford some protection against price declines, eventually leading to superior capital appreciation.
In contrast, value stocks are usually desired by bargain-hunting investors drawn to inexpensive price-to-earnings and price-to-book multiples; an attractive dividend yield and payout ratio; and an unleveraged capital structure. Such investors believe that if a stock's intrinsic value is sufficiently higher than its market price, it has a margin of protection against severe price declines and yet still offers potential for capital appreciation once other investors discover it is undervalued.
Here again, persistent trends based on business and market cycles can provide profitable opportunities for those using active ETF management. Switching between growth and value stocks whenever one style offers better trailing-two-month returns than the other is a strategy that can achieve better results in the long run than simply buying and holding an investment in either style.
Consider that this strategy correctly selected the group of stocks having superior returns in 128 of the 238 months studied, or 54.2% of the time. From the same 1988 to 2007 time period, the strategy produced a 15.5% annual return, which was 2.8% greater than the Russell 1000 Value Index's 12.7% and 4.8% above the Russell 1000 Growth Index's 10.7% (Figure 1). Although the strategy has a somewhat higher 13.8% annualized standard deviation than the Russell 1000 Value stocks' 12.6%, it has substantially lower volatility than the Russell 1000 Growth stocks' 16.4%. Its Sharpe ratio is 0.80 while the Russell 1000 Value's is 0.64, and the Russell 1000 Growth's is 0.38, and this indicates a superior excess return per unit of risk.
This active growth/value strategy's maximum drawdown of -27.5% is similar to the Russell 1000 Value's -27.7%, and both have an identical recovery period of 15 months. The drawdown is a significant improvement, however, over the Russell 1000 Growth's drawdown of 61.9%, a loss which had not yet been fully recovered by October 31, 2007 (Figure 2).
The significance of these differences is evident in Figure 4. For an initial $1.00 investment on February 29, 1988, the active strategy had a terminal value of $17.06 on October 31, 2007, while the same dollar invested in the Russell 1000 Value strategy had a terminal value of $10.44 and invested in the Russell 1000 Growth strategy had an end value of $7.40. This active growth/value strategy can easily be implemented using iShares' Russell 1000 Growth Index Fund (IWF) and iShares' Russell 1000 Value Index Fund (IWD). Both have small expense ratios of 0.20% and small tracking errors.
Domestic Versus Global Stocks
The recent trend toward globalization has unleashed strong secular and cyclical forces. These can provide opportunities for profitable tactical adjustments in portfolios that hold strategic positions in both U.S. and global investments.