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February 01, 2007 at 02:00 AM
In a series of articles appearing in Investment Advisor (September 2005, January 2006, and February 2006), we criticized the market-cap/value-growth characteristic grid used for categorizing and evaluating equity managers. Among other things, we argued that keeping equity managers in a box hurts performance and provides few, if any, risk reduction benefits.
The information we and others present confirms a performance deficit that could be as high as 300 basis points, with risk reduction benefits one-seventh of that provided by traditional diversification alternatives. We present statistics that boxes (e.g., small-cap value) are not really asset classes and, in addition, selecting a fund based on its box designation provides no risk reduction benefits when compared to randomly selecting funds without regard to their box designation.
In a June 2006 Investment Advisor article, John Rekenthaler, VP of research and new products at Morningstar, challenged some of our tests, but agreed with our conclusions regarding the box problem. There is thus support for our proposition that boxes are a problem when it comes to categorizing managers.
What’s an Advisor to Do?
The challenge for advisors is to find a box alternative that provides a way to categorize and evaluate equity managers that does not trip over itself with respect to investment performance. In this article, we present just such an alternative which harkens back to the original meaning of equity style. Style, we argue, is the way a manager goes about analyzing, buying, and selling stocks. Style is not what the manager ends up holding, but rather how the manager goes about making investment decisions. Thinking of equity style in this way, and categorizing and evaluating managers accordingly, solves many problems in the current system.
As a starting point, we believe that equity managers ought to tell investors how they go about making investment decisions and then stick to that style. So the first step in the new process is to ask managers how they manage money and, in turn, use the answer as the basis for categorizing and evaluating the manager.
We refer to this system as “adult” portfolio management, as compared to the current “playpen” portfolio management, in which a manager receives a box designation from an outside service and is then expected to stay in that box when making investment decisions.
The focus on box consistency is an unhealthy consequence of the current system. Successful managers cannot be both box and style consistent. They must choose one over the other. We believe, and our evidence backs us up, that style consistency is more important than box consistency.
A true style-based system, with a dozen or so well-defined styles and many associated elements, has a number of advantages when compared to the current boxed system. Most importantly, a manager, pursuing a true equity style rather than staying in a box, has the opportunity to deliver improved performance. This is because managers can focus on the most highly-rated stocks rather than being forced to limit themselves to less desirable picks within their box. As we show in our September 2005 IA article, forcing a style manager into a box seriously degrades the quality of her stock selections and, consequently, leads to performance deterioration.
Some have expressed concern about allowing managers such freedom and wonder whether this will lead to a manager simply doing whatever they wish without regard to the stated style. We have a similar concern, so for a style based system to have integrity, there must be a matching style audit that holds the manager accountable and thus assures the investor that their money is being managed as advertised.
Performance Evaluation
One of the greatest challenges facing both investors and managers is how to evaluate investment performance. Despite hundreds of indexes available for benchmarking performance, it is often the case that neither the manager nor the investor is happy with the resulting benchmark. We believe this is the result of a fundamental flaw in the current system.
Let’s say that we live in a world in which people are categorized by physical characteristics, with hundreds of measurements provided for each person, such as height, weight, hair color, and so forth. In such a world, a company might request people within a particular height/weight range to apply for a job opening. After going through the selection process, a person is hired for the job. The performance benchmark for that person is based on the average for all people falling within the height/weight range requested.
It is not long before those within the company begin to feel something has gone wrong. The new employee might be performing well with respect to the benchmark averages, but is not accomplishing what is needed. This represents a particularly perplexing situation since, on the one hand, the benchmark comparison is flashing good performance, while, on the other, the results within the company are unacceptable.
