A sometimes-overlooked tool in the adviser and plan sponsor’s analytical toolbox is investment manager style. Style is used to help segment different asset classes and investment managers into comparable subgroups, such as categorizing a growth manager as “growth” as opposed to “value.” The objective is to assist in building diversified portfolios that are exposed to return factors from many different sources. Using style to compare managers and determine talent simplifies this task.
The most common way to think of style is with equities, for which style factors have been studied extensively. Familiar market capitalization and investment strategies include growth, value and taking a market-oriented approach to portfolio construction, and these have been popularly represented by Morningstar’s 3x3 style box.
Style is measured in several ways, with holdings-based the most often used. Holding-based analysis defines a style’s attributes—such as price-to-book ratio, earnings growth and market capitalization—and then applies these attributes at the portfolio level to assign a fund or manager a style. The key is that different styles have different factors of return and each one can contribute to a diversified portfolio. But this only holds when an investment conforms to its style, which is why a study of style is important.
When an investment deviates from its typical style, such as when a growth manager purchases value stocks, this is known as style drift, and it can make controlling risk and understanding where and how a portfolio is allocated more difficult. If investment managers wander outside their mandate, it can shift the risk and sensitivities of a portfolio dramatically. Given that mutual funds are required to only disclose their holdings quarterly, they could undergo a portfolio shift without the investor ever knowing about it. This is a key reason why choosing investment managers that take style seriously and adhere to their mandates is necessary for effective portfolio management.
Style also helps with performing due diligence on the investment manager, although it is important to keep in mind that certain style factors can outperform the broad market for long periods of time. So how do advisers and plan sponsors distinguish between an investment manager’s talent and an advantageous market environment for a particular management strategy? By differentiating the market into styles, advisers can choose the appropriate index to benchmark and use standard investment due diligence methods to monitor and compare managers. But since benchmark indices utilize their own attributes and factors when assigning a style, advisers need to choose indexes with style definitions that conform to their own.
Style analysis can seem arbitrary at times, but it is immensely useful for selecting, conducting due diligence and monitoring the performance of an investment manager. While imperfect, style is a valuable tool for analyzing and comparing managers across asset classes.
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