“Oh give me land, lots of land under starry skies above, don’t fence me in,” by Cole Porter and Robert Fletcher, isn’t just a cowboy song–when it comes to managing an investment portfolio, fences, or perhaps style boxes, may not make the best neighbors. At the IA Wealth Advisor Summit, Craig Callahan, founder and president of ICON Advisors, Inc. in Greenwood Village, Colorado, made a compelling case for releasing portfolio managers from the constraints of style boxes. In fact, he said that hiring a manager to manage to a style box could mean that investors do not get that manager’s best picks, a thesis Callahan first discussed in the September issue of IA, (see original story )
A panel including Ranji Nagaswami, vice chairman and CIO at AllianceBernstein, in New York; William Fries, managing director and portfolio manager at Thornburg Investment Management in Santa Fe, New Mexico; and moderator Philip Edwards, managing director of Standard & Poor’s Investor Services in New York, discussed whether style boxes are necessary.
Callahan says that part of the issue is “style” versus “characteristics” of a fund. He defines “style” as the “method of investing” and characteristics as the grid that typically makes up style boxes: “value, blend or growth; and small-, mid- and large-capitalization.” Style constraints “cost about 300 basis points in performance” annually, he says, citing a Wermers, University of Maryland 2002 working paper that attributes 3.23% alpha to style drifters in the top 10 percentile. When you think about it, if a manager picks a stock where the market cap increases from small cap through mid cap to large cap, don’t investors want to be there for the ride? If she’s got to get rid of it when it goes out of her part of the grid, what happens to the rest of its run? “Give a manager the ability to determine what box to go in, to find the sweet spot of the grid,” argues Callahan, adding that managers with a “rigid style and system can be pulled to the sweet spot on the grid,” but they need the freedom to be able to go there.
But there’s more than one approach to thinking outside the grid. “Growth and value are distinct styles,” says Nagaswami, “cap matters, but all-cap offers flexibility.” Global funds afford their managers the freedom to invest domestically or around the world. The approach she suggests includes–in the same portfolio–both global growth and global value–the “freedom to go around the world. All else is sub-optimal.” Citing the Russell Growth Index and the Russell Value Index, Nagaswami says they are “completely non-correlative,” and that both investing disciplines revert to the mean, and that’s why, she says, an equity portfolio should hold both. Find high-alpha generating managers in growth, and value, with a global mandate, (or split domestic and international equity allocations 70%/30% respectively,) and allocate 50% overall to value, and 50% to growth. Be disciplined about rebalancing–volatility skews the balance. Nagaswami’s approach echoes Callahan’s in stepping outside of the style grid, but does that from a totally different angle.
In his 30-plus years in investment management, William Fries says he “mostly didn’t worry about style.” He worries more about volatility and risk; “when things go bad, clients can want to bail,” out, often at the worst possible time. If clients are risk averse, Fries would rather construct a portfolio with lower volatility if that makes clients comfortable. Fries describes the Thornburg methodology as “comprehensive value” based on fundamental research, and investing in three categories of stocks: “Basic value, consistent earners, and emerging franchises.” Fries says basic value stocks are cyclical, with low valuations relative to net assets and earning power; consistent earners are the Blue Chips–non-cyclical with stable revenue streams, and steady growth, but priced below historical norms; emerging franchises are companies that are establishing leading positions in their marketplaces–these are the highest risk companies in the portfolio, so no more than 25% overall is invested in this category and no more than 2% of the portfolio is invested in an individual company in the emerging franchises group. It’s a completely different outlook from Nagaswami’s and Callahan’s, and again outside the box.
S&P’s Edwards says, “most funds don’t manage to the box.” Callahan says it’s the marketing people that use the grid most–they say they can sell a certain type of fund, and that’s what they ask for.