Figure A: A small-cap growth portfolio
The assignment of mutual funds and stock portfolios to style boxes has helped money managers achieve portfolio diversification, strategic asset allocation and better evaluation of portfolio performance. Like all shortcuts, however, its widespread use has led to its own problems.
What is growth; what is value?
Value investors have traditionally sought out companies whose stocks are priced below their worth. Growth investors have looked for companies whose business prospects are bright and whose revenues and profits are growing faster than the market overall.
Unfortunately, there’s no consensus on what the real worth of a given company is, or what the most reliable indicia of growth are. Some value investors look to buy stocks of companies where the market value is less than the price a private buyer would pay to buy the entire company. But by definition, there’s no publicly available source of a private buyer’s likely price.
Likewise, some growth investors look at growth rates for a company’s revenues or earnings by projecting past trends into the future or otherwise estimating the unknown. Again, there’s no readily accepted source of reliable estimates of future business success.
Compounding the problem of determining whether stocks fit the growth or value mold is the fact that the terms “growth” and “value” aren’t opposites. If the constituent stocks can be assigned to more than one category, how can a portfolio of those stocks be placed in one of the style boxes? This is precisely what happened to the popular Vanguard Growth Index and Value Index funds. More than half the stocks in the S&P 500 Index appear in both funds, albeit with different weightings in each.
Pigeonholing managers
As style box analysis has become prevalent, fund managers have found their portfolios must remain in their accustomed boxes; otherwise, they risk losing assets because of their “style drift.” This pressure has forced many active managers to make their portfolios look more like others in the same style box, which of course also makes their returns more like those of their peers in the same box.
Several recent academic studies have looked at whether style box analysis has affected how the money flows to active portfolio managers. All have come to the conclusion that less money has flowed to managers who don’t constrain their discipline to a style box. In turn, more money has flowed to those who do constrain their portfolios and who become, in effect, “closet indexers.”
In my experience, the most salient characteristic of a good investment manager, and especially of a good stock portfolio manager, is discipline. Without a clear, well-defined strategy, an investor is much more likely to act on emotion and follow the crowd. Those who buy and sell only because others are doing so are almost certain to get whipsawed—that is, to buy high and sell low.
Consider, for example, a manager pigeonholed as a small-cap growth manager who bought Widget Consolidated years ago. The company has succeeded wildly and now, known as Widget International, is a large-cap rather than a small-cap stock. The manager, who believes the company is still in the early stages of its growth (think Google), faces a dilemma. Should he sell Widget and try to replace a great idea in his portfolio with what may be an inferior one, or should he hold Widget and risk losing assets because of his style drift? Because portfolio managers are usually paid according to their total assets under management, our pigeonholed manager has a strong incentive to sell Widget, even though retaining it would be better for his clients.
Both a company’s market capitalization and its style (whether growth or value) are heavily influenced by a company’s popularity in the overall market, shifting categories as a stock goes in or out of favor. The portfolio manager who must adjust his portfolio based on other people’s views is likely to see his portfolio perform no better than those of his peers.
Strategic investing
As a counterpoint to style box analysis, research firm AthenaInvest has developed a strategy-based rating system for mutual funds and portfolio managers. AthenaInvest gathered strategy information for 2,400 open ended, actively managed mutual funds. It identified 10 commonly used strategies among the funds, assigned a primary and secondary strategy to each fund regardless of market capitalization, then analyzed the performance of each. Surprisingly, only 91 funds employed the most successful strategy combination, while 282 funds employed the least successful.
Can a strategy-based rating system of portfolio managers overcome the predominance of style box analysis? Only time will tell, of course, since the style box system is now very deeply ingrained. But the wise investor understands that group-think has never been a prescription for success.
