July 16, 2009

Style Points

With a nod to "Hamlet," by William Shakespeare, "that is the question," and it has been hotly debated since Morningstar introduced its "its tic-tac-toe" board of investment styles in 1992. Is it best to make sure your client's equity dollars are divided across most or all of the nine style boxes? Or should you be focused on finding the best fund managers for your clients, regardless of style box?

Quite honestly, I think too many things in the investment world are wrongly presented in "either/or" terms:

  • "Either you own stocks or you own funds."
  • "Either you own mutual funds or ETFs."
  • "Either you use style boxes or you pick the best managers."

It seems to me that the beauty of having lots of investment options is not in limiting yourself to just a few choices on the menu. The beauty is considering all available options in your quest to maximize client returns at a desired level of risk.

I chuckle at how Morningstar is often vilified in this debate:

  • "Morningstar's style boxes are too restrictive."
  • "They force advisors to constantly rebalance client portfolios, especially when style drift occurs."
  • "Style boxes force you to hold assets in underperforming sectors."
  • "Morningstar misses the forest for the trees with style boxes. You simply can't fit every investment style or strategy neatly into nine boxes."
  • "Investing is all about absolute returns, not distilling the investment process down to making nine bets to ensure that at least one pays off."

The truth is that Morningstar is neither a saint nor a sinner for developing style boxes. Morningstar isn't forcing an advisor to do anything when it comes to style boxes. Morningstar is merely presenting an approach to help quantify portfolio diversification, portfolio monitoring, and asset allocation. Using style boxes is not inherently good or bad. It's just a one of a number of tools that advisors have at their disposal.

Likewise, eschewing style boxes to focus on finding the best fund managers is not a good or bad strategy. It's just another approach, one that could work or not work for your clients.

Interestingly, advisors who use ETFs for the bulk of their clients' assets have answered the question posed at the beginning of this article. And they have answered it in favor of using style boxes. The fact that you use ETFs rather than actively-managed mutual funds speaks volumes as to how you see yourself adding value in the investment process. And that's okay. Combining low-cost, tax-friendly ETFs with proper asset allocation (i.e. style-box adherence) can be a winning formula for advisors and their clients.

But if you go down this road, it is essential that you not just settle on covering the various style boxes. You want to maximize that style.

Typically, the way investors choose the "best" fund to cover a particular style box is to 1) narrow the universe to funds that meet the Morningstar criteria for that style box; 2) select funds based on such factors as fund expenses, past performance, manager tenure, and risk-adjusted returns.

While this approach is not without merit, it does ignore one relevant piece of data. Yes, we know the fund is, say, a value fund based on Morningstar criteria. But how much of a "value" fund is it? Said differently, wouldn't it be nice to be able to choose a value fund based on which fund actually is the best value play in the group? That is, which fund is composed of the value stocks most likely to outperform other value stocks?

Unfortunately, you can't do real-time analysis of mutual funds. You cannot deconstruct the fund down to its individual components...analyze each stock based on its value properties...and assign a value score to each stock and to the fund overall.

But you can with ETFs.

As I have said before in this column, a huge advantage ETFs have over mutual funds is their transparency. By knowing in real time what an ETF owns, investors can make objective, quantifiable judgments as to the relative attractiveness of ETFs based on a sum-of-the-parts analysis.

For example, let's say you like the large-cap value space and want an ETF to cover that style box. A host of ETFs in the market cover that space, including the iShares S&P 500 Value Index (IVE), iShares Russell 1000 Value Index (IWD), iShares Morningstar Large Value Index (JKF), and the PowerShares Dynamic Large Cap Value (PWV).

Which ETF actually scores better in terms of value?

In order to develop a "value" score for each ETF, I turned to my firm's proprietary Quadrix stock-rating system. Quadrix scores more than 4,000 stocks based on more than 100 variables. The variables cut across six important categories: value, momentum, earnings estimates, performance, quality, and financial strength. (For details on these variables, please click here.)

Scores in each category are computed based on a weighting of each of the metrics in that category, and those category scores are combined to form an Overall score. Quadrix scores (0 to 100) are percentile rankings--a score of 90 means the stock ranks in the top 10% of all the stocks in the Quadrix universe.

The table (here) lists the aforementioned large-cap value ETFs with Quadrix Overall scores. These scores were computed based on a weighted average of the Quadrix scores of the individual components. The table also includes additional Quadrix information, such as the percentage of a fund's assets that score above 80 Overall, as well as Quadrix scores for the individual categories.

Notice the Value score for each of the four ETFs. This Value score takes into account 20 different valuation metrics for each stock in the ETF. While all of these ETFs are value funds based on Morningstar criteria, the PowerShares Dynamic Large Cap Value has the highest Quadrix Value score of 74. Interestingly, the PowerShares Dynamic Large Cap Value also has the highest Quadrix Overall score relative to the group. And it sports the best Momentum and Quality scores (Momentum and Quality are good proxies for growth), making it not only the best value fund but also the best "growth" fund in the group. What's more, PowerShares has done an excellent job of keeping lousy scorers out of the portfolio. Indeed, the ETF includes no stocks that score below 20 (the bottom quintile) in Quadrix Overall.

To be sure, you have to pay up for the PowerShares ETF. The expense ratio of 0.63% is two to three times greater than the expense ratios of the other three ETFs. Now, expenses matter. And the fact that the iShares S&P 500 Value and iShares Russell 1000 Value have $2.8 billion and $7.0 billion in assets, respectively, (versus $254 million for the PowerShares Dynamic Large Cap Value) is probably due in large part to their very modest expenses. But here is a case of advisors perhaps putting too much emphasis on fees and not appreciating the advantages, especially in the area of style that the PowerShares ETF brings to the table. Indeed, the PowerShares Dynamic Large Cap Value has more than earned its premium fee--over the last 12 months, the fund has outperformed the other three large-cap value ETFs by approximately 10 percentage points. And over the last three years, the PowerShares ETF has had a lower standard deviation of returns while putting up a much stronger Sharpe ratio (the Sharpe ratio is a measure of excess return per unit of risk) than the other three ETFs.

Bottom line: ETF transparency has added a powerful dimension to style-box investing by providing the opportunity for advisors not only to group funds by style, but also to rank those funds based on style. Advisors who exploit this opportunity will no doubt enhance the value they bring to the client relationship.

Chuck Carlson, CFA, is chief executive officer of Horizon Investment Services and the author of "Winning With The Dow's Losers" (HarperBusiness). David Wright, CFA, provided research assistance for this article.
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