Interest Rates and the Relative Performance of Style and Size-Defined Indices

This paper reconciles the principles underlying style diversification to both the observed patterns in relative returns and recent findings on the efficacy of style rotation. I show that observed patterns in the evolution of relative returns of style and size-defined indices are the result of differences in the interest rate sensitivities of growth relative to value stocks, and large relative to small stocks. Specifically, I show that growth and large cap stocks exhibit greater interest rate sensitivity than value and small cap stocks respectively. These differences in interest rate responsiveness are attributed to findings which on balance indicate that growth stocks are more highly levered than value stocks, and large caps are also more highly levered than small caps. There is thus a traceable relationship between stock attributes and risk factors that are manifested in relative returns.