A simple question asked over 25 years ago, “How should we group and evaluate active equity fund managers?” has evolved into a powerful foundation for rethinking how we look at markets and investment managers.
The answer to that question is the widely accepted style grid of market capitalization and price-to-earnings ratios, which was a largely arbitrary organization lacking substantial research or academic foundation. Regardless, the style boxes’ widespread adoption has had tremendous unintended consequences as managers are incented to adhere to style boxes and track arbitrary benchmarks.
Style Grid: A Leaderless Stampede
The leaderless stampede into the style grid has driven our focus to a very limited set of criteria, and research reveals the price we pay when evaluating fund performance in this manner. Minimizing style drift and tracking error, both demanded by style grid adherents, leads to underperformance.
One study by Russ Wermers of the University of Maryland on the causes and consequences of style drift reports that the greatest drifters outperform those that drift the least by 300 basis points. This is because fund managers are unable to successfully implement their strategies because they must purchase stocks other than their best idea stocks to minimize drift and tracking error as measured relative to their arbitrarily assigned benchmark. The wholesale adoption of the style grid has created strong performance-destroying incentives within the industry.
A powerful alternative is to organize managers by the investment strategies they pursue. Once constructed, these statistically valid peer groups can be used for a wide variety of applications including: benchmarking, manager evaluation, fund selection, stock selection, portfolio construction and tactical management.
Investment Strategy as the New Foundation
Investment strategy — or process, or methodology — is the actual way a manager goes about analyzing, buying and selling investments. Strategy encompasses the manager’s general approach to stock picking as well as the specific elements upon which the manager focuses. This concept can apply to other asset classes.
As an example, a Valuation manager (one of the 10 equity strategies to be introduced shortly) identifies and invests in undervalued stocks. The elements used by the manager to implement the valuation strategy might include PE ratios, valuing future cash flows, or being a contrarian. Drilling down further, the specific criteria used by the manager, such as purchasing stocks with a PE of less than 15, are the manager’s secret sauce and are not part of strategy categorization.
Armed with this basic, yet essential understanding of how professionals manage portfolios, organization around investment strategy is an intuitive approach. Anyone who has looked at a large universe of managers quickly realizes there is a broad spectrum of investment strategies and a wide range of specific investment elements.
Identifying the strategy of U.S. and international active equity mutual funds is accomplished by gathering “Principal Investment Strategies” information from each fund’s prospectus (SEC-mandated, 1998) which is input into a strategy identification algorithm. This algorithm has been fine-tuned using an iterative process involving manager interviews, gathering principal strategy information, eliminating keywords that generate false signals, and settling on a manageable number of strategies.
Over the last 10 years, tens of thousands of pieces of strategy information have been gathered for the 3,000 or so (ignoring share classes) U.S.-based active U.S. and international equity mutual funds. The identification algorithm assigns specific strategy information to one of 40 elements (i.e. the specific things managers do to implement their strategy), which are then assigned to one of 10 equity strategies. The ten equity strategies are listed below.
For example, Competitive Position managers focus on business principles, including quality of management, market power, product reputation, competitive advantage, sustainability of the business model and history of adapting to market changes. Economic Conditions managers take a top-down approach based on economic fundamentals. And so forth for the other eight strategies. Those that believe equity managers deviate from their stated investment approach and therefore question the value of self-declared strategy should review my working paper that summarizes the initial test results.
The strategy database is updated monthly and has captured data starting from 1980. This is a self-identification process, so the number of funds varies across strategies. Summary strategy benchmark statistics are provided below.
Applying a Strategy Framework
Clustering managers based on their self-declared strategy helps avoid the problem of comparing funds that are actually pursuing very different investment approaches. Other benefits include:
- Managers are free to pursue their stated investment strategy.
- Managers following similar investment processes are grouped together.
- Strategy-based peer groups remain stable over time, allowing for long-term comparisons.
- Returns are more correlated within strategies and less correlated across strategies.
Once the universe is organized this way, useful applications begin to appear.
- Strategic and tactical portfolio construction based on strategy can be implemented.
- Managers can be ranked by their consistency and conviction.
- Stocks held by strategy peer groups can be identified.
- Expected returns based on market preferences for strategies can be calculated.
The strategy framework also helps to diversify an equity portfolio beyond capitalization and PE, improving diversification with strategies that have different performance patterns. If portfolio managers prioritize the pursuit of their strategy above style grid categorization, and do so consistently, financial advisors and investment consultants are able to select funds and build portfolios with better characteristics and designed to work well in a range of market conditions.
Lastly, as outlined in this study, the consistent pursuit of a narrowly defined strategy, as well as taking high-conviction positions in the manager’s best ideas, is the path to superior fund performance.
The New Foundation: An Intelligent Organization of the Markets
The concept of investment strategy is widely known and discussed in the industry. Strategy is not only an intuitive way of thinking about investment management, but also provides a superior framework for understanding investment markets in general.
I refer to this as an intelligent organization. It is intelligent because it is based on the strategies being pursued by thousands of active equity managers, each attempting to earn superior returns by consistently pursuing a distinct strategy. It is dynamic and driven by the collective intelligence of thousands of highly resourced active managers. This contrasts with the limited characteristic-based frameworks such as the style grid.
A strategy-based approach yields a clearer picture of the markets and, in turn, investment management. The resulting framework can be used to organize, rate and view managers; build and manage portfolios; and evaluate investments and markets. We will further explore these activities in future articles.
— More by C. Thomas Howard:
- Portfolio Management in the Active Equity Renaissance
- Behavioral Finance Is a Promising Alternative to MPT