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Investing in style on ZSE

Tafara Mtutu
The word “style” is often associated with fashion and glamour, but it has garnered traction in the sphere of investments and wealth management in recent years.

Style, in this context, refers to a market anomaly that an investor can take advantage of when seeking superior returns compared to the market. ‘

These style anomalies comprise patterns and relationships found in the cross-section of stock returns data, which contradict the existing asset-pricing models and the efficient market hypothesis.

The building blocks of style investing were set by Nobel Laureate Eugene Fama and researcher Kenneth French when they aptly explained market returns using value and size factors as well as expected excess returns.

In their research, they found that value stocks tend to outperform growth stocks, while small caps often outperform large caps.

Value stocks are equities that are relatively undervalued compared to their peers.

They are often characterised by low price-to-book and price-earnings ratios.

Growth stocks, on the other hand, have higher-than-average metrics when compared to their respective peers but these metrics are usually justified by the stronger-than-average growth expectations for these businesses.

The size and value factors were found to explain as much as 95% of the returns in a diversified equities portfolio.

More factors were later added to the Fama and French Three Factor Model, such as momentum, volatility, and quality, but the additional variance explained by these factors has been too small relative to the original factors and some consider the additional effort in incorporating these factors to be incommensurate with the benefit that accrues from the exercise.

To this effect, there has been a rise in ETFs whose investment strategies mirror one or more of these style anomalies.

According to etfdb.com, there are over 110 Value ETFs, 280 growth ETFs, 77 small cap ETFs, 860 large cap ETFs, as well over 2,000 other ETFs along the spectra of value and size.

In addition, there are some ETFs that are driven by the other factors, such as volatility and momentum ETFs, and some that blend these styles.

A simple study of these anomalies on the ZSE reveals that factor-based investing combined with discretionary investing could have resulted in above-market returns in 2021.

In particular, small cap fund investors emerged winners among hypothetical value, growth, small cap and large funds on the bourse.

In this study, four equally weighted portfolios were created with the following constituents: the large cap fund’s basket comprised Delta, Econet, Cassava, Simbisa Brands and Innscor while the small cap fund had Edgars, Truworths, General Beltings, NTS, Zimpapers, Turnall, Starafrica, and Getbucks.

The inclusion of these stocks was driven by market capitalisation as well a discretionary method of selection that favoured liquidity.

The selection of constituents of the value and growth funds was based on historical price-earnings ratios relative to the respective sector averages and complemented by fundamental analysis.

Stocks with traditionally lower-than-average price-earnings ratios and good fundamentals made up the value fund (Econet, Delta, NMB, and Innscor) while stocks with higher-than-average price-earnings ratios and strong growth potential made up the growth fund (Ariston, Simbisa Brands, Proplastics, Starafrica, Cassava).

The results of the performance of these stocks between January 2, 2018 and December 31, 2021 reveals that the small-cap fund outperformed the market in 2018, 2019 and 2021, but failed to beat other funds and the stock market in 2020.

The large cap fund and value funds delivered similar returns between 2018 and 2021, and this is largely attributed to similar constituents in both funds.

The growth fund outperformed all other funds and the stock market in 2018, but registered mild performance in 2019, 2020 and 2021.

It is also interesting to note that the ZSE All Share Index only outperformed all funds in 2020, and this warrants the relevance of factor-based investing on the ZSE.

This simple exercise is not comprehensive enough to quantitatively draw inferences about the performance of style funds in Zimbabwe and relative to global size and style funds, but it gives merit to the potential of style investing on the ZSE.

There are several limitations to this analysis which the reader must be aware of.

Firstly, there is hindsight bias, which assumes that the selection of the constituent stocks would have been the same before the beginning of the analysis time frame, which hardly holds true.

For example, the analysis excludes stocks that delisted after 2018, which would have been included in one or some of the hypothetical funds.

Falcon Gold, a small cap stock that delisted in November 2020 would have been part of the analysis.

In addition, Starafrica corporation would not have been part of the growth fund in 2018 given the overbearing debt at the time.

Also, historical performance does not infer future strong performance, as was observed by the small cap fund between the first half and the second half of 2021.

However, there is scope for style-driven funds and a small cap fund to make their debut on the bourse as additional ETFs in the near future.

  • Mtutu is a research analyst at Morgan & Co Research. — tafara@morganzim.com or +263 774 795 854.

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