Most investors think of mutual funds in terms of the nine-grid style boxes that divide funds into growth, value or blend and large-, mid- or small-cap categories. But many institutional investors classify funds by more precise classifications, says Jeb Doggett, managing director of Barra Strategic Consulting Group.
|Jeb Doggett |
Barra Strategic Consulting Group
|Recent Daily Interviews|
Tracy Pride Stoneman
TSC: Why do you say that growth, value and core, also known as blend, are misleading ways of categorizing mutual funds?
Doggett: Growth and value are misleading because there are many flavors of growth and value. Comparing managers within one of those categories is like comparing apples and oranges. For example, one growth manager might have a growth-at-a-reasonable-price philosophy, whereas another can have a growth-momentum philosophy. Those are very different types of philosophies and would result in products with different characteristics. To simply lump them in as growth funds is misleading because when evaluating the levels of risk and return, you are not comparing two things that are the same.
Growth and value are legitimate and helpful investment categories at a higher level, but once you get down to the specific-product level, they are too broad to be helpful. TSC: How, then, can you come up with a sufficient number of categories to describe the many types of investing styles? Doggett: There are almost an infinite variety of philosophies out there, but we can probably do better than simply growth, core, value. Do we need to go to the extreme of categorizing the minutest detail? There is definitely some middle ground that would be helpful both from a retail buyer's perspective and from an institutional buyer's perspective. TSC: You believe that skill rather than style is going to become the dominant means of assessing portfolio managers. How would you define skill? Doggett: Skill is adding value in ways that are consistent with your objective, or getting rewarded for taking specific positions. One way to measure skill is to ... group managers together by philosophy and compare their performance. To give you an example, suppose you have a growth manager who adheres to a philosophy of growth-at-a-reasonable price: They are looking for growth companies, but they also are considering valuation, as opposed to a growth-momentum manager who is looking at growth prospects and not focusing on price. Being in a market environment that over the last 18 months has rewarded value, one would expect the growth-at-a-reasonable-price manager to outperform the momentum manager, but without understanding their specific investment styles as well as their intent, you wouldn't be able to conclude which manager had more skill. Understanding in advance what the manager is trying to do and then measuring whether they were successful at that is the only way to define skill. There certainly are times when a manager has a style that falls into favor and then they get rewarded for that. That's not skillful. That's lucky. Another example would be different approaches to value investing. One approach might be deep value, or contrarian investing, where a manager looks for companies that are at the lowest end of valuation ranges. A relative-value manager, on the other hand, might be looking for companies that are attractive relative to their industry's average or their own history. TSC: So, how many different styles would you propose having, rather than the basic grid of nine: growth, blend or value, in regards to small-, mid- and large-cap? Doggett: Particularly in the large-cap band, you could easily have three flavors of value or growth. For value, I would suggest deep value, plain value and relative value. On the growth side, I could see having growth-at-a-reasonable price, plain growth and then growth momentum. Because mid- and small-cap fund managers tend to have broader investment philosophies, I would apply only two types of investment categories to these funds: deep-to-plain value and plain-to-relative value, and growth-at-a-reasonable-price-to-plain-growth and plain-growth-to-growth momentum. For core, I don't have as much of an issue because a core product effectively represents the market: both growth and value. TSC: So, have you broken your categories down into a total number of style boxes? Doggett: No, because I don't want people to focus on the idea of style boxes. We would rather have people think about style footprints. With style boxes, investors think they have to own something in every box, and I don't think that's the right way to go about investing. Style footprints are a multidimensional way to evaluate managers. Instead of using a single metric, such as price-to-book value ... you use a series of style characteristics, such as earnings growth or price momentum or volatility or yield, to measure a manager's portfolio. This will give a more detailed understanding of the nuance of their investment philosophy or style. TSC: You said that institutional investors already have been veering away from the traditional style boxes and using more sophisticated tools. When did institutional investors begin using such tools, and can you give examples of them? Doggett: They began using them five years ago, and they are now becoming quite prevalent. A specific example would be performance attribution analysis, which compares a product's performance to a benchmark and measures relative sources of return. Specifically, if a product has outperformed a benchmark by 5%, such a tool would let you know what drove that performance. Was it from the beta policy or market timing? Was it from the style exposure or was it from the sector or industry selection? Was it from specific security selection? By using performance attribution analysis, you will see exactly what drives a manager's performance. For example, if a manager outperformed a benchmark but it was because of style exposure -- i.e., the manager was in the right slice of the market because of their investment philosophy -- maybe a buyer would be less inclined to give him credit. On the other hand, if a manager outperformed a benchmark because of security selection, then the evaluator would be inclined to give him a lot of credit. TSC: Do you expect that the Morningstar-type style boxes will become obsolete? Doggett: They won't become fully obsolete because they are useful as general guidelines. But this fall, Morningstar is evaluating how they classify managers by style, and that's an indication that using a single metric isn't as useful as multiple metrics.