Morningstar Advisor - Winter 2008 - (Page 42) Spotlight The investment community has a few hundred million reasons to prefer flexible management styles to constrained styles. John Rekenthaler the findings of one study into an overall investment lesson. Other Attempts That pretty much kills off any remaining research on the subject. For example, Thomas Howard and Craig Callahan of Athena Investment Services (a money-management platform) conducted a hypothetical test based on four quantitatively defined models based on the strategies of Ben Graham, John Neff, William O’Neil, and T. Rowe Price. This test is said by the authors to demonstrate that “characteristic boxconstrained investing” lagged the portfolios of unconstrained managers by 339 basis points from 1995 to 2003. The authors reached this conclusion by forcing the four models’ picks to fall within a single style-box square for the constrained test and by permitting the model do what it wished for the unconstrained version. This is all quite nice, but that and the price of tea in China are equally relevant to the question at hand. No actively managed fund in existence places every stock in a single square of the style box. In fact, many funds that consistently place in the same style-box square are widely diversified among positions of various styles. The authors’ exercise says nothing about the Morningstar style boxes unless they can measure at which point their hypothetical portfolios—not the individual holdings, but instead the entire portfolio— would cross the style-box boundaries. They cannot, and do not. Indeed, it is quite obvious that the wild and crazy version of the Ben Graham clone would never have budged from the small-value segment of Morningstar’s style box. Finally, there are papers that do not attempt to measure adherence to investment style, but rather use other measures of managerial flexibility. These papers very broadly address the issue of how much freedom to give to portfolio managers and are sometimes cited as further evidence in favor of flexible managers. A 2005 paper (“Industry Concentration and Mutual Fund Performance,” Kacperczyk, Sialm, and Zheng) posits that managers who concentrate their bets within a few industries tend to beat managers who spread among industries. The following year, another paper (“How Active Is Your Fund Manager? A New Measure That Predicts Performance,” Cremers and Petajisto), using a measure called “active shares,” claims that managers who run funds that look less like indexes are superior to closet indexers. However, these papers do not address our issue. For example, a go-go fund that held only the shares of companies that were in the computer software, medical technology, and Internet businesses industries would score well by both papers’ measures, having a concentrated industry focus and a high active score. However, that fund would consistently land in Morningstar’s small-growth stylebox square. Wrapping Up Great Moments in Style Box History 1992 Morningstar Style Box Is Born A simple tool to see what type of stocks a fund holds. 1996 Morningstar Categories An innovative way of grouping fund based on actual holdings, a la the style box. 1998 Tune-Up No. 1 Flexible boundaries that shift with market replace hard market-cap and valuation cutoffs. 2002 Morningstar Style Indexes 16 indexes, based on style box methodology, prove to be more style pure than conventional style-based indexes. Morningstar Market Barometer Shades of green and red measure intensity of market moves within style box. Tune-Up No. 2 Growth components add precision to style calculation. 2003 Morningstar Ownership Zone Depicts scope of a fund’s holdings across style box. It is easy to understand the appeal of so-called flexible managers who thrive by bouncing among style-box squares. The notion that managers should be permitted freedom, rather than be nagged at by outside parties, is intuitively attractive to investors and advisors. For its part, the investment community has a few hundred million reasons to prefer flexible management styles to constrained styles, since flexible styles command a higher management fee. Finally, outside parties who recommend and comment upon managers after doing fund-by-fund research—among them, Morningstar, by the way—may find their expertise to be more highly valued. However, we currently do not know if the story is true. Next issue, we will. K John Rekenthaler is Morningstar’s vice president, research and new product development. 42 Morningstar Advisor Winter 2008
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