NEW YORK (Real Money) – I had a little free time this week, and so naturally I spent it testing numbers and theories of investing.
I have long been fascinated by the theory of Cliff Asness of AQR Management and a few others that combining growth-oriented momentum investing with a value approach inside a portfolio would outperform the overall market. It is a great theory, but a lot of the great theories deal with such large subsets of stocks they cannot be easily replicated in real life.
Must Read: 12 Stocks Warren Buffett Loves in 2014
Buying the top decile of momentum stocks and bottom decile of price-to-book-value stocks would involve more than 1,200 stocks. The growth and value ETFs (exchange-traded funds) contain far more than that just pure growth pure value, so they are not the best approach either.
I sorted through a bunch of mutual funds and chose two for my hand study. For growth I used the T. Rowe Price New Horizons Fund. With an average price-to-earnings ratio and a commitment to small-cap growth stocks, the fund looked like a good proxy for high-growth momentum stocks. The fund owns stocks like Netflix (NFLX) , Puma Biotechnology (PBYI) and Shutterstock (SSTK) that are high-growth, high-multiple stocks. It has beaten the market over the past decade and is a good proxy for the growth component of the portfolio.
The Undiscovered Managers Fund (UBVAX) is a top-performing value fund over the past decade and will be our value stand-in. The fund is managed by Fuller-Thaler research and is managed on value-oriented behavioral characteristics.
Once I selected my funds, I looked at what would happen if you combined them in a portfolio and rebalanced them. The mix does handily outperform the market over the past decade, with an 11.54% compared to the 8.07% average annual return of the S&P 500.
For most of the time, they smoothed out the overall returns; one fund tended to zig and market conditions made the other one zag. The exception was 2008, when as we know all correlations went to zero and just about everything went the same way at the same pace. If you backed out 2008 in the four years leading up the big meltdown, the mix beat the market by a few percentage points, and in the years after the crash of 2008, the mix blew the market away with 22.5% annual return compared with the stock market's 16%.
My little back of the envelope study showed that this is in fact a very good idea that should be used in long-term accounts such as 401(k) plans.
Focusing on the stocks way out on the edges of the market, with the highest growth stocks as one half of the portfolio and the most undervalued as the other half does in fact lead to market-beating returns and lower volatility most of the time. Buying the best small-cap growth fund and the best small-cap value fund and rebalancing annually is a much better way to manage those IRA and 401(k) accounts than an index fund.
Curiosity got the best of me and I decided to test what would happen if you took a really risk- adverse fund that used cash as an investment class in what the manager considered overvalued markets. The only guy on the planet who has a more risk-adverse approach to the markets than myself is Steve Romick of the FPA Crescent Fund (FPACX) . This growth and income fund can own just about any asset class and can also go short stocks he considers overvalued. When asked for my favorite mutual funds by some of my more passive investment friends, I always say this fund is at the top of the list.
Before my math and statistical-oriented friends start screaming: I know I am cherry-picking and maybe even curve-fitting the data a bit. However, it does give us a pretty good idea of what we might achieve using some simple performance and correlation tests to put together a long-term portfolio using this 50-50 approach.
Using the New Horizons Fund and FPA Crescent returns improved markedly. The blend earned a 10-year average return of 12.3% and the 2008 drawdown, while still significant at 29%, was less than the markets' 37.7% decline. In the five years before the crisis, the blend earned 10.48% a year and in the five years since, it has achieved annual gains of 21.98%.
It appears that combining growth and momentum stocks with deep value stocks does work very well. Everyone argues about which is better, but it appears that value and growth actually work best when they are combined.
At the time of publication, the author held no positions in any of the stocks or funds mentioned.
Editor’s note: This article was originally published on Real Money Nov. 24 at 3 p.m. EST.