Fund managers who think they can add value by simply letting their approach guide them to the stocks in which they expect to make the most money face another concern-the business risk involved in getting profiled by the Style Police.

One of the more important questions is who is likely to add more value: investors or advisors who fine tune asset-class exposure at the margins or talented fund managers with proven track records who use their experience and investment processes to find the stocks in which they will make the most money? Although overall asset allocation is important and should be kept in line with investment goals, in some cases, there is probably more opportunity to add value by giving talented managers enough room to buy their best ideas.

The Style Police

The style police are, for the most part, investors who start their investment decision-making by determining their desired exposure to broad asset classes and/or investment styles, such as large growth or small value, and then choose individual funds to meet that allocation. Their decisions on whether to buy or continue to hold a fund are based on the fund's adherence to the style for which it was originally chosen. Thus, if a fund experiences "style drift," these investors may sell part or all of their position and replace it with a fund that more purely represents the desired style or asset class. Style policing is more common in the institutional world, especially among pension consultants and advisors. But everyday investors have become increasingly aware of the issue and are more apt to apply it illogically-mistakenly believing that a suitably diversified portfolio can be attained by simply buying funds in each of the nine boxes on the popular tic-tac-toe-style grid. And many less-sophisticated investors incorrectly assess the portfolio drift as tantamount to lack of discipline or commitment to an approach (it may or may not be).

The History Of Style

Style analysis originally evolved as a means of drawing better comparisons among like managers and creating more-appropriate benchmarks. Although most equity managers historically shared some combination of three basic investment goals-growth, income and capital preservation-it was clear that some groups of managers ran money in very different ways from others. Some were looking for companies with accelerating earnings, while some looked for those selling at a discount to their intrinsic value. Some focused on larger caps, and some invested mainly in smaller caps. Some were opportunistic and didn't emphasize any one specific area. Investors in the old days might simply have dismissed a manager who underperformed a broad market index, without considering whether the kind of companies the manager bought were in or out of favor and without assessing the performance relative to a similar index or group of managers. But as asset allocation became more common in the '80s, thanks in part to the increased availability of computing power, investors learned they could allocate assets to different classes in pursuit of desired risk-and-return characteristics.

From an asset-allocation standpoint, the objective in defining an investment style is to identify groups of securities whose behavior is influenced by their common characteristics. By identifying distinct styles within the equity universe, investors can theoretically allocate among these groups based on the way they interrelate to one another, thus reducing the level of overall portfolio risk incurred to reach a target return. This is the basis for modern portfolio-theory tenets, such as optimization and the efficient frontier, which involve blending assets in an effort to create the optimum balance of risk and return.

Unfortunately, as the style analysis phenomenon took off, the original purpose of the style box-benchmarking-was lost. The tool outstripped the problem it was designed to address, as style boxes went from representing groups of like managers to full-blown asset classes. Fund companies rushed to fill in the boxes. Value shops launched growth funds, and vice versa. Investors began to feel that to be diversified required exposure to all of the boxes. But this focus on style has created problems. Investors increasingly are unwilling to allow managers the flexibility to simply look for compelling stocks. Intuitively desirable traits-independent thinking, opportunism and broad-based knowledge-become less valuable if a stock picker is constrained to an artificial stock-picking universe.

Anyone who entertains the notion of adding meaningful value to a portfolio by delicately balancing the weighting between large and small, growth and value and so on, should consider just how difficult it is even to define these groups. Mostly it is done based on some combination of P/E and P/B (price-to-book) ratios. But sometimes, companies that we know are value will show as growth. Consider, for example, an older manufacturing company undergoing a difficult period that after taking one-time charges has just a tiny fraction of earnings left. Even though its stock price already may be depressed, with its minuscule earnings denominator, its P/E could be sky high. Book value can help, but book values can be misleading, too. For example, JDS Uniphase shows up as a value stock, based on tangible book value because it carries massive intangibles on its books as a result of the many acquisitions it has made.

If the level of disagreement as to which stocks populate a style group creates disparity this wide, how can an advisor reasonably hope to make the precise predictions of returns and future correlations needed to add value at the allocation level beyond just determining an approximate target weighting?

Even if you succeeded in defining style to a sufficiently tight degree to be able to gain confidence that you could add value by setting your allocation, the funds in any style group are moving targets. Beyond the qualitative assessment of management, there are two main empirical ways to gauge a fund's style. First is portfolio analysis-measuring the statistical characteristics of the actual underlying portfolio holdings. There are several problems with this approach, and the biggest is the data often is too old to be a reliable indicator of a fund's current style position. Funds are required to report holdings only once every six months, and they have until 60 days after the end of the period to do so. As the data ages, market caps and valuation characteristics of the overall market can move-sometimes sharply-and make comparisons between funds meaningless. Some fund-data providers revalue old holdings (which, depending on turnover, may have changed by a significant amount) at more current prices, but at that point the information is fading fast.

Style also can be gauged by analyzing return patterns. This method determines the most likely sources of the returns by computing them mathematically. This technique has some advantages over portfolio-based analyses because it only looks to explain measured behavior. This approach says, in effect, that if it walks like a duck and quacks like a duck, then for practical purposes, it needs to be regarded as a duck for portfolio-allocation purposes. Because some characteristics and relationships can be hard to identify (such as multinational U.S. companies that correlate more closely to foreign benchmarks) returns-based style analysis can be useful. The biggest problem is that the number of data points required to get reliable information pushes back the time frame to which the analysis applies. Essentially, the best you can do is gain a broad sense of composite style, over a longer period and centered well in the past, but not of current style or recent shifts. In short, there is no reliable way to know where you stand in terms of style at a given time, and so decisions you make are imprecise, at best.

Asset-Allocation Limitations

If it is difficult to get an accurate read on where a portfolio stands with regard to asset-class exposure, it is even more difficult to make accurate predictions of how various asset classes are likely to perform. A purely quantitative approach to developing an optimal asset allocation requires the user to make subjective inputs of returns for each class, their standard deviations and the degree to which each class will correlate to the others. But as anyone who has played with an optimizer knows, sometimes even tiny changes to the inputs can send the results careening in wildly different directions. Coming up with reasonable inputs poses a significant challenge. Using long-term historical averages can serve as a starting point for these inputs, but many asset classes don't have long enough histories to be useful, and in many cases, macro factors that we know qualitatively may be extremely unlikely to recur may have had significant influence on past behavior.

Another problem is that some correlations are purely accidental and therefore not reliable. Anything may have a correlation to something else, but is there a reason for it? In short, guesses for returns, standard deviations and correlations are truly just guesses with large potential for error. If one were to assume that all of these guesses were within some tolerance range for each variable for each asset class, you would see a range of results that would include just about any allocation. These problems are so significant that most optimization software programs allow the user to employ restrictions to force allocations to be within a "reasonable" range for each asset class. It is these subjective restrictions that wind up having the most effect on the results of the allocation model. To borrow from The Wizard of Oz, it is not far from the mark to say that when the veil of science is lifted from optimization, a very mortal person is revealed to be pulling the strings.

What About The Manager?

A fund may have style-specific criteria as an integral part of its stated investment philosophy. In some cases, this could be the result of the manager(s) having developed an investment approach, the characteristics of which happen to be described by those style criteria. Mason Hawkins of Longleaf Partners is a good example. He did not set out to develop (or apply) an approach to fill a style box, but it happens that his deep-value approach and very strong discipline fit the value style well and will not likely deviate. In other cases, a fund company may have decided that it needed to offer a product in a style box that had been empty. But more confidence is gained with an approach that is defined independently of top-down style considerations, in which the kinds of stocks that are purchased are an offshoot of the fundamental research and not of a preconceived product plan. Andy Stephens, who runs Artisan Midcap, is another good example. The mid-cap universe in which he largely invests is a function of his thoughtful and detailed process, not of a marketing decision by fund-product people.

Some funds have no style-specific criteria in their stated approach. They may operate for years in a single market segment (as defined by style) and then gravitate elsewhere as the market environment changes and they find better stocks to buy. These managers may be pigeonholed into a particular style by investors and then are derided for failing to adhere to a style label that they had no say in creating.

Fuel On The Style Fire

A mutual fund management firm is like any other business: Its managers almost always are looking to make the company grow. To grow means they need to gain assets. This requires either having exceptional performance or rolling out "new" funds. Exceptional performance is difficult to attain, and it is poorly suited as a driver of asset growth because the assets it attracts usually serve to diminish future performance.

Catering to investors' demand for broad style exposure has led many fund companies to come up with increasingly narrow ways to differentiate their products (such as micro-cap or small-to-mid cap). As they roll out these products, they have a vested interest in promoting the "style purity" mentality to enhance the differentiation of products that in many cases may be quite similar. On the other hand, funds that don't fit into a style box are more difficult to market and promote. Consequently, they bring in fewer assets and are less valuable to a fund company.

Satisfying style lineups creates other problems with funds. If a fund company has a broad range of products that use a similar underlying approach, the ideas that derive from what might be a decent process can get diluted as they get allocated into the appropriate buckets. In the case of funds that are created solely to fill a style box, the level of talent and the depth of the investment process can be lacking. The fund's reason for existence is not first and foremost to employ a careful and in-depth approach to finding stocks that its managers believe will make the most money, it is to use an existing inventory of "ingredients" to create a predetermined "flavor." It might taste close to what it is supposed to be, but it is unlikely to be great. And even at funds where the approach does drive the stock selection, managers may become influenced by business considerations, such as the impact on assets that might result from shifting their style. In short, they may forgo investment decisions in which they have a higher level of conviction that they will make more money because they (or their bosses) fear they would lose assets. A number of managers have told us, off the record, that they are cognizant of style issues when making investment decisions and feel pressure to remain style pure.

Fire The Manager-Or Shareholders?

Style's best use is to provide a context for understanding how some managers run money and for meaningful performance comparisons. Style also lets us define and implement broad allocation guidelines. In this regard, a fund that underwent a style shift should be re-evaluated under the following conditions:

The shift is not consistent with the understanding of the manager's approach-perhaps he or she has implemented changes that require further evaluation.

The shift could signify portfolio moves being made for business, rather than investment reasons, such as a smaller-cap fund buying larger stocks to accommodate more assets or to chase a hot area of the market to appease impatient shareholders.

The move is so extreme that broad allocation targets and the risk parameters of the portfolio are compromised.

Performance comparisons look better as a result of the fund straying from the stated or expected style.

Not caring what others think may not make you a great manager, but it is certainly a trait that most great managers have in common. The truly great investors of the world do not care what the "style police" or anyone else thinks about what they are doing. They have sufficient focus, courage and discipline to stick to their convictions, regardless of any business or marketing considerations, and believe that ultimately this will be in everyone's best interests. In effect, these managers "fire" those shareholders who are overly style-conscious by refusing to accommodate them.

Understanding Is Essential

To use active managers in an asset-allocation approach requires a thorough understanding of the manager. Foremost, you should have confidence that the manager will be able to add value relative to the asset-class benchmark. If you do not believe this, but you have confidence in your asset-class allocation, then you should be using index funds to ensure that you do not inadvertently lose any value you add through allocation to bad manager selection. Further, you should have confidence that the fund's approach makes it suited for the asset class it is being slotted to fill. If you are willing to grant some room, you still need to know what to expect. For example, does a smaller-cap manager hold onto winners if he still likes their prospects, or does he sell at a certain market-cap cutoff? Is a value manager who appears to buy a growthlike stock doing so because it is what is "working" in the market, or is it because, based on his analysis, the stock is at a significant discount to intrinsic value?

It is important to evaluate the multiple exposures across styles that many funds have. Larger-cap funds may still own some smaller-cap stocks, value own some REITs, etc. Just knowing how much is allocated to each fund doesn't ensure that the underlying holdings are accurately mapping back to your target allocations.


A major question in deciding how to evaluate and manage a portfolio on the basis of style is how much value is really being added by stripping managers of their ability to buy what they want. Asset allocation has too much imprecision for investors to delude themselves that they can add value very far beyond the first, broad-brush allocation. Those with extremely high confidence that the bulk of their value will come from allocation decisions are better candidates for indexing. Investors who want a basic allocation that provides diversification and a framework to exploit selective and compelling opportunities at the asset-class level should consider active managers who are granted enough room to add the value they were hired to add. For a good stock picker, this value is going to stem from allowing the approach they employ to bear fruit. If you really understand your manager and the portfolio moves in one style direction or another, you will recognize whether style drift is a concern (such as asset growth or a change in approach) or whether the move reflects his or her approach is uncovering opportunities.

Steve Savage is editor of Litman/Gregory's and The No-Load Fund Analyst. This article was adapted from that publication.