The study was done by John Rekenthaler, president of Morningstar‚s online advice business; and Michele Gambera and Josh Charlson, two Ph.D.s at the firm.
Returns-based style analysis rose dramatically in popularity during the 1980s, after it was developed by William Sharpe. It proved particularly useful for situations in which information about a fund or a portfolio‚s direct holdings was not available. It has been widely used for the last decade by pension consultants, financial advisors and plan sponsors.
However, the authors note returns-based analysis possesses several limitations. In particular, it can serve only as a constrained estimate of a portfolio‚s current positions. So a critical issue is measuring the margin of error. "The returns-based approach runs into more trouble with more flexibly managed portfolios," Rekenthaler says.
For instance, a fund whose manager moves from Pepsi to John Deere to eBay is likely to have a higher error factor than one who moves from Pepsi to Coca-Cola.
A major problem with holdings-based style analysis is the timeliness and cost of the data. Mutual fund companies now are required to publish their holdings only on a semi-annual basis. "What was surprising was that a 12-month-old portfolio will match up more closely with what‚s in the portfolio today than returns-based analysis," Rekenthaler says. "Holdings-based style analysis is more timely than most people think."
He cites an example of a fund that allocates 37% of its assets to large-cap growth stocks. Returns-based analysis might show the fund‚s large-cap growth position at 25%, while holdings-based analysis would measure it at 33%, he adds.
Hedge Funds On A Roll
The hedge-fund industry–helped by manager performance and an inflow of new money–grew 38% last year to total $563 billion in assets, according to a recent survey.
The survey by the Hennessee Hedge Fund Advisory Group also found that individuals continued to be the largest source of new capital, followed by the fund-of-funds industry.
"Our greatest concern continues to be the ability of the industry to absorb the incoming money flow without diluting the talent pool and thus hurting performance," says E. Lee Hennessee, chairman of the Hennessee Group. "However, most managers seem to have a good sense of their capacity limits."
The annual survey, introduced in 1994, consists of responses from 766 hedge-fund managers representing more than $141 billion in assets.