The first article in this series introduced the concept and benefits of using investment strategy as an alternative to the style grid for forming active equity mutual fund peer groups. As presented in that article, evaluating funds in terms of self-declared strategy provides a powerful framework for constructing and managing equity portfolios. This article presents specifics on how this can be accomplished.
A popular approach for active equity portfolio construction is to diversify across the style grid by investing in a small-cap value fund, a large-cap growth fund and so on for the nine or more style boxes. Strategy diversification is a similar concept in that you invest in funds pursuing different strategies.
Strategies provide superior diversification relative to style boxes as demonstrated in this study which details a series of tests comparing the two frameworks. A successful formation of active equity fund peer groups should have the lowest across-group-return correlations and the highest-within-group correlations, which leads to:
1) the greatest diversification when investing in funds from different groups, and
2) funds within a peer group all employing a similar investment strategy.
The cross-fund correlation tests conducted demonstrate that forming peer groups based on self-declared strategy outperforms style box peer groups on both dimensions. That is, when classifying funds by strategies there is higher correlation within each strategy (reflecting commonality) and lower correlation between each strategy (reflecting differences) relative to the correlation data within and between style box categories.
Building a Strategy-Diverse Portfolio
A straightforward way to build a strategy-diverse portfolio is to select a fund from each of the 10 strategies, but this approach can be improved upon by examining each strategy’s historical performance as summarized in the table below.
As shown, strategies have performed quite differently over time, with Future Growth delivering the best returns at 13% annually and Risk the worst, underperforming Future growth by 6%. Based on these return differences, it does not make sense to invest in all 10 strategies. We recommend limiting fund portfolios to the top six strategies: Future Growth and Competitive Position, which are the two that have outperformed the S&P 500, along with Opportunity, Quantitative, Valuation and Profitability, each performing within 1% of the market.
This leaves out Social Considerations, Market Conditions, Economic Conditions and Risk, which have all unperformed by more than 2%. Some may prefer social impact investing, and if something other than returns is a criterion, then a Social Considerations fund could be included.