But the performance advantage for style-sloppier funds continued to hold, to a point, further down the food chain. The top quintile of style-active funds, as well as the second quintile, each generated 16.1% annual net returns. The performance, however, bottomed out in the third quintile at 14.4%, before the numbers started improving. The lowest quintile, which contained funds that rarely deviated from their style mandate, generated a return of 15.6%. And the 5% of funds least likely to stray from their style mandate generated a return of 16.2%.
Wermers also looked at stock-picking skills of this universe of managers. Once again, he said the managers who weren't shy about deviating from their style produced substantially higher returns. The top quintile of style-active managers oversaw portfolios that beat their style benchmarks by 1.8% a year, while the median quintile enjoyed no extra performance. Even more dramatic, the top 10% of style-inconsistent managers beat their style benchmarks by more than 3%.
Certain types of funds were more prone to style-creep than others. "Our study finds the growth-oriented funds have higher levels of style drift than income-oriented funds, and small funds have higher levels than large funds," Wermers says. "Managers who have better career stock-picking track records and higher levels of career portfolio turnover tend to engage in trades that cause more active style drift. Further analysis shows that these managers deliver superior future portfolio performance, which indicates that they are not simply overconfident."
Steve Hardy, president and founder of Zephyr Associates Inc., a major source of returns-based style analysis software, is familiar with the contradictory papers, but declines to choose a favorite. In an interview, however, Hardy expresses misgivings about forcing a manager to fit into a certain style niche. "The more you constrain someone, the less likely they can do their job well," he suggests. At the same time he scoffs at the futility of so many managers who trample over style considerations as they chase hot stocks. It's only the truly skilled managers like Bill Miller, Peter Lynch and George Soros, he says, who can pick stocks within very loose parameters and not crash and burn with the ambulance chasers.
What Hardy seems to suggest is that the success of a style-consistent fund could lie in whether or not a fund manager toes the style line willingly. "The issue, then, is whether managers who are style-consistent are that way because they are constrained in some way," he says.
Hardy says he suspects that a manager who, for instance, only invests in small-cap value stocks because that's what he knows and that's what he likes, and that's what he thinks about every day, should do well. But the manager who invests exclusively in small-cap value because he could lose his job doing otherwise is more likely to fail.
If you ultimately conclude that style loyalists do hold an edge, pinpointing these funds won't necessarily be easy. The most recent quarterly analysis of funds by Standard & Poor's suggests that most equity funds, over lengthy time periods, are style creepers. During the three-year period ending in June 2003, for instance, S&P calculated that only 54.1% of domestic funds stuck to their stated style. During the past five years, that statistic drops to 37.4%. "The message of the story," says Srikant Dash, S&P's index officer, "is really that investors and financial advisors who are advising them should keep track of style changes."
According to S&P's three- and five-year statistics, large-cap value and growth funds were the most likely to remain within their style boxes. During the five-year period, 63.4% of large-cap growth and 63.5% of large-cap value funds stuck to their discipline. In contrast, mid-cap and small-cap blend funds were singled out as the biggest style violators. During the five-year period, a mere 13.2% and 11.2% of these mid-cap and small-cap funds remained style-consistent. Of course, it should be noted that S&P's numbers were generated using returns-based style analysis. What would have happened to the numbers using portfolio-based style analysis? It's anybody's guess.