A Response to Improving on Morningstar Style Boxes

The following is in response to Stephen Dodson’s article, Improving on Morningstar Style Boxes, which appeared last week.

I am pleased to see Stephen Dodson taking on the scourge of the active equity mutual fund industry: the style grid. I would like to build upon the arguments presented in his article.

A few years ago we conducted an extensive research trying to identify who launched the style grid. As part of this research, we spoke with Russell Investments who provided information for what we believe was its initial launch. In 1984, the number of active equity funds was exploding and Russell was casting about for ways to categorize funds so that advisors and investors could make sense of this bewildering array. They tapped Bill Sharpe to help them address this problem. During a brainstorming session, Sharpe, as business faculty are wont to do, wandered to a chalkboard and drew a two-by-two matrix.

As all good academics believe, business challenges – no matter how complex the finance, marketing, or management issues they involve can best be summarized in a two-by-two matrix. Since small-firm and low-PE effects were all the rage in 1984, he proposed the axes be market capitalization and the average PE of the stocks held by the fund.

Thus was born the style grid.

It was launched that year, and Russell was stunned when, by the following year, the investment industry identified “style drift” as a serious problem for active equity mutual funds. They knew there was no research behind the style grid; it was simply put forward as a way to organize the growing array of funds. But the law of unintended consequences had already taken effect.

Since then, a leaderless stampede has positioned the style grid, despite all its shortcomings, as a dominant organizing force in the industry. Investors pay a huge price for this costly dependence on an arbitrary categorization system.

Since that fateful day in 1984, the evidence has turned strongly against the style grid. As Dodson points out, knowing a fund’s style box tells us little about the investment strategy its manager pursues. After all, the most critical thing to know about a manager is how he or she goes about earning excess returns. Isn’t this central to the decision of whether or not to “hire” the manager?

Research studies conclude that, since they were first identified in the late 70’s and early 80’s, both the small firm and PE effects have disappeared. Other studies find that the greater the style drift, the greater the return. Thus constraining managers to a specific style box hurts performance, a result well known by Morningstar and other purveyors of the style grid. Morningstar specifically cautions against restricting a manager to a style box. But this does not stop legions of advisors and consultants from elevating style drift to one of the worst crimes a manager can commit. It is hard to imagine a worse system for categorizing active equity managers.

Read more articles by C. Thomas Howard, PhD