In the September 2005 Investment Advisor, we showed that characteristic (value-growth and market capitalization) constrained investing costs investors almost 300 basis points per year. Then, in the January 2006 issue, we demonstrated that characteristic boxes are not asset classes since they are not compositionally unique, have high correlations with one another, and experience changing membership over time.
Thus we argued that it is a waste of time to use characteristic boxes for “asset” allocation. Instead, the stock market should be thought of as a single asset class rather than as nine unique “asset” classes.
These articles highlight the limitations of value-growth- and market-capitalization-constrained investing, pointing out that this system of investing evolved out of convenience without an empirical basis. We challenge advisors, consultants, and investors who continue to use the system to prove that it is a sensible system. This article constitutes a further challenge to constrained investing in which we will address the purported links between risk management and the use of style boxes.
While we are confident that our research supports our findings, over the last few years at various conferences many advisors and consultants have nevertheless told us of several reasons why they still think constraining managers is good for investors. Two of those reasons involve reducing or controlling risk. One of the arguments is the notion that investing in several characteristic boxes (e.g. small-cap value and large-cap growth) is essential to controlling overall portfolio risk. Furthermore, many advisors believe that it is important to constrain managers to a particular box so that the proper level of diversification can be maintained.
The second argument in support of constrained investing goes beyond diversification and focuses on the relationship among market cap, growth, and volatility. In this argument, the advisor takes on the role of limiting the percentage of small-cap or growth stocks in a portfolio so that the portfolio adapts to the risk tolerance of the investor. This exposure control is currently accomplished by constraining individual managers on the basis of market capitalization and growth. However our research presented below shows that when a portfolio is composed of multiple managers, focusing on an individual manager is an unnecessary and expensive way to control risk. Instead, individual managers should be allowed to pursue their unique style, while risk is controlled at the overall portfolio level.
This, we argue, allows managers, advisors, and investors to move up to the win-win-win situation of unconstrained investing: managers pursuing winning equity styles, advisors efficiently controlling risk at the portfolio level rather than at the individual manager level, and investors taking advantage of superior return opportunities at an acceptable level of risk.
Boxes as a Risk Management Tool
Many advisors use characteristic boxes (CBs) as a way to manage overall portfolio risk. This is done by investing with managers who are categorized in different CBs, such as placing money with a small-cap value fund, a large-cap value fund, and a mid-cap blend fund. The possible choices are represented by the traditional Morningstar characteristic grid shown at right.
The extreme strategy is to invest in nine different managers, each representing one of the nine characteristic boxes. The idea behind this approach is that returns of managers residing in different boxes move independently of one another and thus reduce overall portfolio risk.
In our January 2006 IA article, “Boxes Are Not Asset Classes,” we presented evidence that CBs are not unique asset classes and that the average correlation among CB indexes is 0.80. Since risk reduction potential–when risk is measured as the standard deviation of return–is one minus the square root of the average correlation among investments, the risk reduction potential of investing across CBs is slightly more than 10%. This demonstrates that diversifying across CBs provides insignificant risk reduction benefits.
In order to test this proposition with real investment managers rather than with CB indexes, as we did in our January 2006 IA article, we gathered annual return information on 342 mutual funds over the period 1996 through 2002. These represent all non-indexed, U.S. domestic equity funds with complete 1996-02 return data and categorized by Morningstar as either large-cap value (LV), large-cap growth (LG), small-cap value (SV), or small-cap growth (SG) in 2002.
We selected this time period because it falls within the period of our earlier study (“The Problematic Style Grid” research report available at www.athenainvest.com) and thus we are able to compare our results with the mutual fund results. In addition, this period represented a very volatile stock market and challenging risk-management environment. We limited our sample to the corner boxes in the Morningstar characteristic grid, as this gives the CB approach (i.e., investing in managers residing in different CBs) the best opportunity to perform well since the corners have the lowest correlations across CBs (see table below).
The mutual fund results appear in the top portion of the table. The first row shows results for portfolios constructed by investing in four managers, one from each of the four corner boxes. This is the approach preferred by many advisors and is presumed by them, without evidence, to be essential for controlling overall portfolio risk. When portfolios are formed by investing in four fund managers, one from each of the four corner boxes, the average standard deviation is 18.9% and the resulting average information ratio (IR = return/standard deviation) is 43 bps/1% of volatility as shown in columns three and four in the table.
We now compare these results to several other portfolio formation methods. Here we are addressing the question of whether it is necessary to diversify based on CBs, as many advisors advocate, or if there are other selection methods that work as well, if not better.
On the next line in the table, the four managers are randomly selected without regard to the characteristic box into which they fall. The results are virtually identical to those of the CB selection approach. As shown in columns three and four, the average portfolio volatility is 19.6% and the investor earns an average of 42 bps in return for every 1% of volatility, versus 18.9% and 43 bps for the CB method. Thus, knowing the CB in which the manager resides does not help in making the portfolio diversification decision. Random selection, on average, is as good. This calls into question the need for mutual fund categories from services such as Morningstar, when the objective is choosing managers for the purposes of risk control.
The next results provide further evidence that CBs are an unnecessary risk management tool. For this approach, four managers are selected from the same characteristic box. This approach is the polar opposite of the currently preferred approach of selecting managers from different boxes. However, the performance is similar to that of the previous two approaches, with an average volatility of 21.3% and an average return per unit of volatility of 41 bps.
Examining the individual boxes on the next four lines, we see that two CBs–LV and SV–outperform the two previous approaches while the other two–LG and SG–underperform. So staying within a CB can produce superior returns to diversifying across CBs! However, the two growth box results have substantially higher volatility and lower IRs than do the previous results. The issue of being overexposed to small cap or growth is an important one and will be addressed in the next section.
Consistent Style but Characteristic Drift