Nov. 22, 2002 — Throughout the mid- and late-1990s, the most crucial investment decision an investor or an advisor made was how much to allocate to growth stocks versus value stocks. Being overweight in growth stocks was the key investment decision, since growth dramatically outperformed value throughout the bubble years.

Today, style-based allocations appear almost irrelevant, with individual holdings becoming more important. According to this week’s scorecard on FundAdvisor, large-cap growth funds were present on the list of both best- and worst-performing funds. The Russell style indexes, used as benchmarks by many money managers, reflect that lack of variance: in the third quarter of 2002, the broad Russell 1000 index was down 16.9%; while the Russell 1000 Growth index fell 15.1% and the Russell 1000 Value index slid 18.8%. The lack of differentiation was still more striking in the Russell 2000 index: the overall index fell 21.4%, while the growth index retreated 21.5% and the value benchmark fell 21.3%.

“To the extent that growth and value index performance and funds are overlapping, this underscores the importance of people understanding what it is they’re really doing when they invest in a fund, and hire complementary managers using different styles,” says Paul Greenwood, director of U.S. equity at consulting firm Frank Russell Co. “These days, it’s particularly important to dig deeper, past the simple definition of a fund as growth or value, and find out what really drives stock selection.”

Since the late 1980s, style has grown to become one of the most important ways investors classify and select U.S. stock fund managers. By the late 1990s, style-based investing decisions were vital: According to a study by Putnam Investments, the average difference in absolute returns between growth and value indexes was 7% between 1978 and 1997, but had skyrocketed to 30% by 1999 as the technology bubble reached its zenith. “Style drift” — any decision by, say, a growth manager to redefine his investment universe as `growth at a reasonable price,’ or by a value manager to purchase stocks that were relative rather than absolute values — was punished as clients defected.

Today, that black-and-white view of style is changing.

“The label is not what is important any more,” says Christopher Acito, a principal at Casey Quirk & Acito, a Darien, Conn.-based money manager consulting firm. “What is important is what is inside the fund. It’s time to think of style-based investing in a new way.”

Greenwood agrees, noting that the two styles, once so distinct, are showing increased levels of overlap. Part of that is due to the collapse in value of technology stocks, which are finally entering the territory of value investors. Growth investors also have been scared out of their normal haunts and into sectors of the market they once would have scorned as stodgy or slow-growth. In an environment like this, the challenge for investment advisors and their clients is to peer past the label on a fund and ask more questions about how its managers define their investment universe.

Even a cursory review of funds’ largest holdings will demonstrate how important that can be. According to holdings information available on FundAdvisor, that overlap shows up in the largest holdings of many funds. Pfizer (PFE) is considered a growth stock by many of the funds that are tracked, such as Avatar Advantage Equity Allocation Fund (AAEAX), Goldman Sachs Capital Growth/A (GSCGX), and BlackRock Large Cap Growth Equity/A (PGIAX). But it has also been one of the largest holding in several value portfolios for much of the year, such as AllianceBernstein Disciplined Value/A (ADGAX) and Enterprise Grp Equity Income Fund/A (ENGIX). Dreyfus money managers have owned Citigroup (C) in both large-cap growth ( Dreyfus Appreciation Fund (DGAGX)) and large-cap value Dreyfus Premier Value Fund/A (DRSIX)). Indeed, other stocks that appear to have acquired a dual identity as both growth and value stocks include household names like Fannie Mae (FNM), Freddie Mac (FRE), Washington Mutual (WM), Tyco (TYC), and retailers like Wal-Mart (WMT) and Sears Roebuck (S).

At Northern Trust Co., Jon Brorson, director of stocks, was astonished when a review of portfolio holdings last summer showed that growth and value managers were building their portfolios around a similar list of core holdings, including Citigroup, IBM (IBM), Avon Products (AVP) and AIG (AIG). Large-cap growth managers owned shares of Goldman Sachs (GS) and Pfizer; their value counterparts were buying Morgan Stanley (MWD) and Merck (MRK). Both had roughly equal positions in shares of Fannie Mae and Freddie Mac.

“The overlap between growth and value investing has expanded since the technology/telecom bubble has burst,” Brorson says. He says investors need to carefully study their portfolios in the current environment where the lines between what represents growth and what constitutes value appear increasingly blurred. Acito agrees, arguing that the overlap is a good reason for investment advisors to rethink how they build balanced portfolios for their clients, and to dig deeply into what drives stock selection at individual funds.

Money managers themselves are well aware of this conundrum. Only a year or two ago, they would have been able to label a stock as either growth or value within seconds. Today, answering that question can be difficult; even impossible. Part of the problem comes from the growing pool of “androgynous” stocks, companies like Citigroup or Pfizer that have characteristics of both growth and value. The investment companies themselves only began to examine the issue in the last few months, and Frank Russell Co. is still planning what likely will be the first comprehensive study to determine the magnitude of this overlap. The answer will be important for investors, all agree.

“Investors need to know they’re getting the diversification they’re seeking,” Brorson says.

Jeff Lindsey, head of large-cap and mid-cap growth equities at State Street Research in Boston, says high growth rates are less believable than they were a year or two years ago, pushing managers into areas that they see as offering trustworthy, if not spectacular growth rates. In some cases, those will be areas that still offer relatively low valuations and continue to attract value investors as well. Lindsey believes the overlap involves only a minority of stocks in a typical portfolio of 100 to 150 stocks.

“It’s not surprising that we’ve got an in-between land of stocks; it’s a function of the market which causes times of greater overlap and times of less overlap,” he says. “Your definition of growth needs to be relative to the opportunities that are available.”

Consultants urge investment advisors to press fund families for information from fund families on whether they have studied the issue of portfolio overlap and androgynous stocks. Some, such as Putnam, have already done so, in reaction to what Jeff Knight, chief investment officer for global asset allocation at the Boston-based investment management firm, calls “a degree of frustration” among money managers about stocks that appear to have migrated from one style into the domain of another.

“Some of our portfolio managers are frustrated because suddenly the names they came to know well and identify with aren’t turning up in their universe any more,” says Knight.

Now buy-side analysts covering technology stocks, undeniably growth stocks for most of the 1990s, say they’re fielding phone calls from value managers instead of growth investors. “We’re doing a lot of education with those guys; they don’t know the space as well, but all of a sudden it’s become value territory,” says one Internet analyst. Growth investors are also venturing into new territory. Lindsey is playing cyclical trends, such as energy, and investing in slow-growing consumer products companies that once he would have dismissed as being too stodgy.

“Who knew we’d have so much interest in investing in beer companies?” Lindsey marvels