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Barra Institutional Style Indices

categories: Investing (Investment Management), RMA, Multi-Asset Class, Research Paper, GRINOLD Richard, DIVECHA Arjun, general

A new way to look at asset allocation
By Arjun Divecha and Richard Grinold

Barra has traditionally seen the market place as multifaceted, and we have captured those facets of the market through factors such as SIZE, VOLATILITY, SUCCESS, VALUE, GROWTH, and the like. The opposite viewpoint is the old, one-dimensional separation of stocks into large and small. Style indices represent something of a midpoint between Barra's multifaceted view of the market and the one-dimensional view. To create style indices we look along the axis of value and growth and end up with a matrix stratification into categories such as large-value, large-growth, small-value, small-growth, and so on.

Style indices are similar to factors in that it is possible to define a style portfolio as a list of stock holdings. Style index portfolios have the added benefit of being a capitalization-weighted list of assets; that is, the critical item in the style portfolio is membership in the list; weighting is always in proportion to capitalization. Every asset in the market gets included in only one of the style portfolios, so we can consider the style portfolios as pieces of a mosaic; put all the pieces together and you get the market.

Using style indices

Style indices can be used in the same manner as any asset allocation device:

  • We can use them in strategy asset allocation to set a long-range target for the asset allocation.
  • We can attempt a relative valuation of the style portfolios and use that information for tactical asset allocation by dividing the stock portfolio into relevant pieces that will allow us to move beyond the simple division into stocks, bonds, and cash.
  • We can use the style portfolios in performance analyzes by asking how much of our performance was due to our strategic asset allocation, how much was due to allocation across the style portfolios (tactical asset allocation), and how much was due to stock selection within the style portfolios.

Characteristics of Barra style indices

Style indices should appeal to institutional investors. For that reason Barra has developed a set of style indices that have two characteristics that institutional investors highly value. The first is low turnover. The second is institutional interest in a security.

Low turnover

We have defined the style index portfolios and the rules for an asset moving from its current assignment to a new assignment to control the turnover of the style portfolios. This is a particular problem along the border between a large and a small grouping, since the small portfolio will see some of its highest capitalization stocks (by virtue of good performance) move into the large category while some (relatively) high-capitalization stocks drop into the small portfolio (due to their poor performance).

To minimize this "trivial" turnover, we have implemented rules that prevent stocks from moving from one index to another unless certain thresholds are exceeded. Thus, the criterion for a stock to move from one index to another is more stringent once it is already in that index. By using these "tolerance bands," we can prevent stocks at the edge of each index from flipping back and forth. In addition, the indexes are rebalanced only once a year (at the end of June) since that also helps to reduce turnover.

Institutional following

The second characteristic institutional investors value is whether a security has attracted the interest of other institutional investors. One measure of this is the number of analysts following the security.

The three Barra style indices

Barra has developed three broad indices that feature low turnover and institutional following. The indices are called Big, Small, and Neglected.

  • Barra Big -- The Big Index has about 1,000 stocks. To be included in this index, each stock must have a sufficiently large capitalization or be followed by a sufficient number of analysts (within the Institutional Brokerage Estimation Service (IBES) universe).
  • Barra Small -- The Small Index has about 2,000 stocks. These are stocks that are not in the Big Index but that are each followed by at least one analyst. In addition, they must have a price and capitalization high enough to interest institutions.
  • Barra Neglected -- The Neglected Index has about 2,000 stocks. These are stocks that are not in the Big or Small indices but have financial data readily available commercially. They must also have a capitalization of at least one million dollars. Since this index represents stocks that are not usually considered investable by institutions, this group is worth following mainly for academic reasons.

Growth and Value sub-indices

The Big and Small indices are then divided into Growth and Value sub-indices called Big Growth, Big Value, Small Growth, and Small Value.

  • Barra Big Growth and Value -- The Big Index is equally split into two sub-indices (based on capitalization): Big Growth and Big Value. We use predicted earnings growth rather than historical growth to assign companies to each index. The criterion for this split is the IBES Median Predicted 5 Year Earnings Growth rate for each company. If the predicted number is not available for a company, we use the Historical 5 Year Growth rate. If that number is also unavailable, we use the Barra Book-to-Price Risk Index to distinguish between Growth and Value stocks.
  • Barra Small Growth and Value -- The Small Index is split into two sub-indices, The Small Growth and Small Value. The criteria for the split are identical to those for the Big Growth and Value indices.
Exhibit 1 shows how the four style indices performed over the past 10 years, relative to the S&P500. Clearly, the differentials in the returns to the four styles are sufficiently great to make strategic and tactical asset allocation between them interesting.