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.