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Stocks of a particular style generally share long-term risk, return, and
correlation characteristics. This helps investors and financial planners
decide how to allocate their assets. An equity fund's style refers to
the types of stocks the fund holds.
Active mutual fund managers define their own investment style, which guides
them in picking individual stocks. For example, a fund manager may manage
a growth fund that reflects a style preference of growth stocks.
The problem with investment style is that it is not consistently defined
within the industry. Terms such as large, small, value, and growth have
a wide range of definitions. This lack of specificity makes it difficult
for investors to measure their risks and rewards, and easier for active
managers to claim market beating returns over a nebulous benchmark.
A growth style includes stocks that are experiencing rapid growth in earnings,
sales, or return on equity. Growth stocks tend to carry low book-to-market
ratios, high price earnings ratios, and usually offer no dividend yields.
Growth stocks are priced much higher than their book values, indicating
a large portion of the purchase price goes to goodwill. Goodwill is basically
the difference between the price and the book value. Growth is somewhat
of a misnomer. The price paid for goodwill is often deflated by news of
lower than expected earnings growth of these companies. Growth stocks
are expected to underperform value stocks and the total market.
A value style includes stocks that tend to carry high book-to-market ratios,
low price earnings ratios, high dividend yields, and are often described
as being in distress. They are thus perceived by investors to be of higher
risk, but investors need to remember that higher risk equates to higher
expected return. The shareholders of value stocks have a high cost of
capital, which equates to a higher expected return for the capital provider.
The capital provider is the investor, or the capitalist. Value stocks
may receive a lot of negative publicity and experience a downturn in their
business.
The styles of large, small, and micro are based on a company's share price
multiplied by the total number of shares. Companies are ranked and grouped
into categories that vary substantially within the investment industry.
For example, as of September 2001, the Russell 2000 index of small cap
stocks had a weighted average market cap of $800 million, while the DFA
small cap index had $600 million, and the DFA Micro cap index had $250
million. Morningstar, Russell, Lippers, Barra, Wilshire Associates, DFA,
Morgan Stanley Capital Indexes, and Standard and Poor's are all considered
reliable sources of style criteria. Each has its own set of rules for
measuring value, growth, large, small, international, or emerging markets.
It is no surprise that the active investor is dazed and confused.
6.2.2
Style Drift
Style drift refers to the tendency
of active managers and actively managed mutual funds to deviate from their
stated or expected investment style. This drift can occur gradually over
time, as in the case of a "small-cap" manager buying larger
and larger companies as their fund asset base grows. Style drift can also
occur abruptly if an active manager perceives opportunities for higher
returns from a different style. For example, a U.S. large company fund
may purchase a high percentage of Mexican stocks, changing the fund’s
style.
6.3.1 Style
Drift Alters Risk Exposure
Style drift creates numerous problems
for active investors. It keeps them from maintaining reliable asset class
allocations for their portfolios. This results in inconsistent exposure
to risk and the resulting variations in expected average returns.
Experts widely agree that over time, asset class allocation is on average
the single most important determinant of variance in investment performance.
The best way to design a portfolio's asset class allocation is to use
historical asset class data.
Active investors cannot use historical asset class data to design asset
class allocations for their portfolios. Many design them by relying on
style labels such as "value," "growth," "large"
or "small" that are carried by active mutual funds. They may
even neglect to design them at all. An active fund usually does not relate
to the risk and return potential of any single asset class. It is unclear
how the reliance on labels that supposedly identify these asset classes
can help active investors design asset class allocations for their portfolios.
This task can prove even more difficult for an active investor who invests
in a separate portfolio of individual stocks and bonds. It is essentially
impossible to rationally design a portfolio's asset class allocation when
the building blocks of the investment strategy used to implement it are
active mutual funds or individual stocks, bonds, or both.
Style drift prevents an active investor from optimally reducing diversifiable
risk, because the manager of a typical active fund does not remain consistently
invested in the same asset class. On the surface, this does not seem to
be much of a problem, but investors who reduce diversifiable risk get
a bonus. The bonus is increased return.
Style drift heightens the uncertainty felt by active investors who have
little idea how their investments will perform and how their performance
will relate to a discrete index. Unnecessary costs and taxes are generated
in efforts to maintain consistency between a portfolio’s asset allocation
and the various investments used to implement it.
The considerable latitude given to managers by active mutual fund prospectuses
often results in style drift. Style labels assigned to active mutual funds
by fund rating services are not particularly helpful to active investors
who rely on them to design asset allocations for their portfolios. For
example, an active investor who wants to design an asset allocation that
includes the asset class of U.S. large company stocks may find an entire
list of labeled “U.S. large company” (active) mutual funds.
The problem is that the investments held by an active fund can change
over time. Investors in the Fidelity Magellan Fund found this out the
hard way when money manager Jeffrey Vinik shifted 30% of the fund’s
assets from stocks to bonds and cash. This must have been an unwelcome
surprise to investors who had chosen Magellan to earn the returns of stocks,
not bonds or cash, and based their asset allocations on that expectation.
That is precisely the problem with style drift. It introduces a lot of
needless uncertainty as to whether investors can implement their asset
allocations, since it is likely that active funds will drift from their
benchmarks. Even worse, there is no way to know which active mutual funds
will survive in the future, much less which ones will be winners or losers.
6.3.2
Style Drifters
Money
manager Jeffrey Vinik's notorious fall from grace after tinkering with
the popular Fidelity Magellan fund in 1996 is one of the most visible
examples of style drift. Fidelity's Magellan was the world's largest mutual
fund, and has been a popular equity investment. In February 1996, Magellan's
asset allocation was only seventy percent equity. Vinik, the fund's manager
at the time, had invested twenty percent of the fund in bonds and ten
percent in short-term marketable securities, betting that long-term bonds
and short-term marketable securities would outperform the equities market.
Instead, the market soared to new heights, bonds fell in value, and Vinik
left Fidelity. The key issue was not the outcome of Vinik's decision,
but the investor's loss of control of the asset allocation process.
As recently as March 1999, Fidelity was still being criticized for misrepresenting
its funds. Steven Syre and Steve Bailey, columnists for the Boston Globe,
took the company to task for including stocks of mammoth companies like
Microsoft Corporation and MCI WorldCom Inc. in its Fidelity Emerging Growth
Fund. The fund markets itself as one that invests in small and mid-sized
companies. Thomas Eidson, Fidelity's senior vice president and director
of corporate affairs, conceded that Syre and Bailey had made a legitimate
point.
Fidelity touted the fund's returns by comparing them to the performance
of small and medium company stocks. In 1998, they performed dramatically
worse than large company stocks. "It's not that uncommon for a fund
to beat its competition by a few points if you're comparing apples to
apples," Syre said in an interview with Brill's Content. "But
this thing was blowing them away."
The Securities and Exchange Commission agreed with the journalists. Fidelity
changed the fund's name to Aggressive Growth Fund and eliminated language
in its prospectus that suggested a focus on smaller stocks.
A recent study by the
Association for Investment Management found that approximately forty percent
of actively managed funds are classified inaccurately, based on the stated
goals versus actual investments. The fund managers are drifting along,
chasing the latest hot trend. All actively managed funds drift from their
benchmark to varying degrees. Only index funds do not drift.
One
way to analyze style drift is to measure the exposure to different indexes
at sequential times. Figure 6-1 illustrates the drifting styles of the
Fidelity Magellan Fund from June 1988 to December 2004. The scale on the
left designates the relative exposure to different styles. Note that the
dark blue zone is a large value index and the light blue is a large growth
index. In June of 1995, it would have been better to classify the fund
as a large value fund, while in February 2000 it would have been a large
growth fund. Style drifters, like the managers of the Magellan Fund, are
altering their styles in their quest for the next winner. Over the last
15 years, Magellan’s style drifting has resulted in returns below
that of the steady hand of the S&P 500 Index Fund. As a contrast,
see Figure 6-2, which illustrates the style purity of a S&P 500 Index
Fund. In looking at the chart you can see a contrast equal to the exposure
between the large growth and large value as represented by the Russell
1000 Value and Russell 1000 Growth.
Figure
6-3 compares the styles of the Scudder Large Value Fund over time to a
DFA Large Value passively managed index fund in Figure 6-4. Finally, Figure
6-5 compares the Vanguard Explorer Fund, which is described by Morningstar
as a small growth fund. As a comparison, see the DFA Small Value Index
Fund in Figure 6-6. Because of the undesirable characteristics of small
growth, DFA does not offer a small growth index fund. In each comparison
the bottom index fund provides more consistent and style pure risk exposure.
Figure
6-1
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Figure
6-2
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Figure
6-3
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Figure
6-4
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Figure
6-5
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Figure
6-6
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6.3.3
Style Drift and the Fama-French Risk Factors
Fama and French identified
risk factors in 1992 that highly correlate with long-term historical returns,
namely company size and value orientation. Style drift between these two
factors for two periods of approximately fifteen years can be seen in
Figure 6-1. On the horizontal axis, Value is a high Book-to-Market ratio
(BtM) and Growth is a small BtM. On the vertical axis, Small and Large
Cap are companies with small and large market capitalization, respectively.
The numbers on the axes are measures of market exposure to each of these
asset classes. The 0,0 point (the crossing of the axes) essentially represents
the entire market. It reflects all of the stocks in the CRSP database
and is the reference for the other measurements.
The green points reflect the average exposure of the funds during the
period between January 1976 and June 1988. The white points reflect average
exposure during the period between July 1988 and December 2000. Note how
far some funds moved from their starting point. This movement reflects
Style Drift and is often an unannounced change in investment objectives.
Other funds barely moved. It should be noted that the data fails to reveal
the many additional shifts in positions that these funds made within each
of the years depicted. These additional shifts drive up trading costs,
generate higher taxes, alter risk, and lower returns.
One of the reasons it
is so dangerous to style drift is because styles are as unpredictable
as stocks, times, or managers. Take a look at how the style of the year
changes over time in the table below. Just follow the light blue International
Small Company, which goes from highest to lowest and back to highest in
the first three years. Can you pick the next winning style? It is no wonder
that both professional and amateur investors are whipsawed into investing
in different styles. But investors who hold onto diversified portfolios
obtain the returns and losses of all top performing asset classes over
time. This method has been shown to substantially improve your returns.
Figure 6-7
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Style Picking
Before discussing the next set of tables, please refer to Figure 6-8,
which provides a legend for the portfolio and index buttons on Tables
6-1, 6-2, 6-3 and 6-4. For further information about these buttons see
Appendices A and B.
One of the reasons it is so
dangerous to style drift is because future style winners are as unpredictable
as stocks, times or managers. Table 6-1 shows the annual returns of the
S&P 500 and 20 index portfolios of different style over the last 80
years. Some investment managers use a strategy referred to as tactical
asset allocation. This is a form of style picking where a manager alters
the allocation of styles based on their prediction of the future style
winners. To illustrate how difficult it is to predict the next winning
asset allocation of styles, refer to Table 6-2, which is ranked each year
with the highest return for that year on the left and the lowest return
on the right. The random rotation of styles from left to right illustrate
the difficulty style drifters have in picking the next winning style.
Table 6-3 provides
the annual returns of the 15 IFA Indexes and the total market index from
CRSP for the last 80 years. In Table 6-4, the returns are sorted so that
the highest is on the left. Note the random rotation of individual indexes
or styles from year to year is virtually impossible for managers to predict.
It is no wonder that both professional and amateur investors are whipsawed
into investing in different styles. But, investors who hold onto diversified
portfolios obtain the returns and losses of all top performing asset classes
over time. This method has been shown to substantially improve your returns.
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