Some advisors cling to the notion of specialization, thinking incorrectly, we believe, that a manager can specialize in a characteristic box. The four styles we tested are those of specialists who select stocks not by style box but by a well-defined methodology or specialty. Graham, O’Neil, Neff, and T. Rowe Price are all specialists, but the highest-ranked stocks selected according to their methods have varying size and value-growth characteristics through time.

Here is an example: What if a manager specializes in selecting stocks that are about to enter a phase of rapid growth? It would be a mistake to attempt to restrict that manager to one box, say, small-cap growth. One of that manager’s top five selections might be a large-cap oil company that just discovered a new oil field. Being large cap, it would not be eligible despite fitting the manager’s stock selection style. There is no specialty style that fits a characteristic box. Once that is accepted, boxes become useless for categorizing, selecting, and evaluating managers.

If you have been using the characteristic-constrained system of investing, take the performance challenge. Compute annual rates of returns on your accounts. Based on our results and those of Russ Wermers, performance will lag by about 300 basis points per year over the long term. Think what that is doing to the value of your practice. In a market of free competition, with free entry and exit, advisors using a deficient system that underperforms will lose clients and go out of business, while advisors who produce higher returns will experience growth.

Many advisors have observed the underperformance of characteristic-constrained investing and have blamed the managers, not the system. The managers do underperform, but we believe a contributor to this underperformance is that they are characteristic constrained. On this dimension at least, it is the system that is to blame and not the managers. By blaming the managers, some advisors have defaulted to using indexes in each box, essentially closet indexing the portfolio. Notice how absurd this is. Taking this approach, 100% of the excess return depends upon the advisor’s ability to time characteristic boxes over time. Most advisors do not have discretion, do not have definable styles, and do not have AIMR-compliant track records for taking on this critical task.

The new role of the advisor is to select a few managers who have complementary styles but not to characteristic constrain those managers. As long as the manager is implementing his or her style, let the characteristics drift. If the advisor and client happen to care about the characteristics of the portfolio, who is in a better position to determine them: the advisor or the manager? The manager is staring eye-to-eye with stocks that meet his or her criteria for selection. Buying favored stocks will determine the portfolio market capitalization and value-growth characteristics. The advisor, on the other hand, is simply timing boxes, not knowing their contents from year to year or which stocks managers will be holding in each box.

Free managers with definable stock selection styles and strict disciplines, and devote your time to counseling, educating, and providing discipline to investors. In this new unconstrained world, advisors remain responsible for selecting investment managers, evaluating performance, and ensuring that the composition and tilts of the overall portfolio are those that are desired by the end client. This is where the advisor can truly add value, rather than pursuing the value-destroying activity of characteristically constraining managers.

Craig Callahan is founder and president of Icon Advisers in Denver and can be reached at C. Thomas Howard is a Professor of Finance at the Daniels College of Business in Denver. He can be reached at