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.