Insight Line—January 15, 2007

Approximately three years have passed since researchers from the University of Alabama Huntsville challenged the investment world’s status quo by suggesting that investors segmenting stocks as either growth or value based solely on the classification of some well-followed indexes may be more apt to evaluate style performance incorrectly.

In short order, those with opposing views answered back with equally appealing arguments on the strengths and merits of style classification.

End of discussion? Hardly. In fact, I suggest that recently published research under the auspices of the Morgan Stanley Quantitative and Derivatives Strategies Group clearly offers an additional twist to the ongoing debate.

For years, investors looking to diversify their portfolios along style benchmarks questioned whether the terms “growth investing” and “value investing” characterized the portfolio manager’s investment style or simply the stocks in the portfolio. Eventually, formula-based metrics from the leading index providers gave investors much-needed clarification: only stocks—not managers—were classified as growth or value. Confident in their newly discovered knowledge, investors rapidly transitioned style investing from nuance to blueprint.

That is until Dr. Dorla Evans and Kenneth Scislaw challenged the status quo. In “Structural Imperfections in the Algorithm of Certain Equity Style Indexes,”¹ they maintain that the most commonly used methodology for style classification—ranking price-to-book ratios and then segmenting them by total capitalization— suffers from fundamental shortcomings. So much so, they suggest, that any investor adhering to an all-or-nothing classification system for portfolio construction may unnecessarily reallocate or rebalance their portfolios—during long-term bull or bear markets—on incomplete information.

Echoing similar sentiments in “How In[ter]dependent are Value and Growth Styles?”² Wallace Yu and Yazid M. Sharaiha of Morgan Stanley found that over the past nine years (1997-2006), “value and growth strategies are interdependent rather than independent.” In short, I believe Yu and Sharaiha verified what Evans and Scislaw argued to be the case.

Granted I am simplifying their findings somewhat, as both teams of researchers display an impressive array of statistical tables to support their contentions. Nevertheless, as I see it, their essentially shared conclusion is unambiguous: investing for style purity is arguably unachievable as numerous stocks are now classified as both growth and value in the most widely followed indices.³ For example, General Electric, as of December 31, 2006 had a 2.8 percent weighting in the Russell 1000® Value Index while simultaneously holding a 2.6 percent weighting in the Russell 1000® Growth Index. This is not to suggest that style metrics should be ignored. Quite the contrary, I see it as a challenge to investors to no longer accept style classifications at face value, as there are undeniably more shades of gray than previously believed.

¹ “Structural Imperfections in the Algorithm of Certain Equity Style Indexes,” by Dorla Evans, PhD, and Kenneth Scislaw, Journal of Investment Counseling, February 2004.

² “How In[ter]dependent are Value and Growth Styles?” Wallace Yu and Yazid M Sharaiha, Morgan Stanley Quantitative Derivative and Strategies, September 2006, ©Morgan Stanley 2006.

³ Ned Davis Research, Chart ba1510, ba1710, ©2006 Ned Davis Research.

This material has been prepared using sources of information generally believed to be reliable. No representation can be made as to its accuracy. The forecasts and opinions in this piece are not necessarily those of Van Kampen, and may not actually come to pass. Information in this report does not pertain to any Van Kampen product and is not a solicitation for any product.