Baseball legend Ted Williams famously created an outline of the strike zone and mapped his batting average in tiny boxes. He figured if he was going to bat .400, he needed to swing only at pitches in spots that gave him the best chance of a hit. Swing in too many of the low-average spots, he reasoned, and you won’t get into the hall of fame.
The difference between an all-star and a bench warmer is all about being in the right part of the strike zone.
Investors have known about mutual-fund style boxes for a long time, but few understand their purpose. Should an advisor identify the best fund in each of the boxes? Should they attempt to capture equal exposure to all styles?
It’s easy to find a single fund that provides exposure to all the boxes. Just pick a broad index fund with the lowest fee, and you’re set.
The debate over factor-based investing
Your philosophy on the use of style boxes should depend on how you feel about the persistence of factor-based alphas. It’s old news that small-capitalization and value investing have outperformed historically in the United States and internationally1. That means investors should swing at pitches in the low and inside corner of the style box (small-cap and value) and let high and outside (large-cap and growth) float by.
This debate is also about cheating the corners within the style box. A smart fund manager who recognizes historical factor advantages might be tempted to let a fund drift to the lower-left of his or her style box. A large-cap growth manager has a better chance of beating the benchmark (a strike down the middle of the box) if he or she overweights smaller and more value-oriented securities. As long as the manager stays within the box, he or she looks like a genius (assuming the small-cap and value premia persist). Doubters can take up the argument with Eugene Fama and Ken French.
This all begs the question – why bother? If you’re building a portfolio of funds that provides the highest expected return for a given level of risk, then why not just select the best funds from the lower left box? Advisors get more hits (alpha relative to a market benchmark) if they swing at pitches that have the highest historical risk-adjusted returns.
1. There is little debate over the fact that value stocks have outperformed on a risk-adjusted basis.But a debate exists over whether the same can be said of small-cap stocks (see here).
Let’s look at a Ted Williams-style strike-zone map of the traditional mutual fund style box. We can segment each of the size boxes (small-, mid- and large-cap) and each of the valuation boxes (value, blend and growth) into nine sub-boxes for a total of 81 micro style boxes. For each box, I estimated 36-month alpha compared to the S&P 500 from 1993-2013 (returns begin in 1990) for 4,243 mutual funds from Morningstar Direct (corrected for survivorship bias). Each little box has an average three-year fund alpha. Dark red boxes have the highest performance relative to the S&P 500, and dark green boxes have the lowest performance.
If each fund is a pitch, then you should be swinging in the red zones if you want the highest average (alpha).
The results aren’t surprising if you’re used to analyzing fund performance using a Fama-French three-factor model. In general, you should swing at low and inside pitches and ignore high and outside ones. Overweighting large-cap growth isn’t a good strategy if you want to make it to the asset-manager hall of fame.
Within each of the style boxes, the story gets more interesting. Managers that overweight low and inside (small-cap and value) within their style box don’t always outperform the high and outside managers, even over a 20-year period. In fact, only mid-cap growth managers won the race by going low and inside. And in the magic lower left small-cap value box, the brightest red square was in the large-cap value corner Over a one-year evaluation period, fund managers are going to underperform plenty of times by going low and inside relative to their style benchmark.
Two questions advisors must answer
This creates two interesting questions. Why would an investment adviser want to pick funds in the large-cap-growth box? And why don’t fund managers always lean toward small-cap-value within their style boxes?
Why would an adviser go high and outside? Anyone who dealt with irrationally exuberant clients during the late 1990s knows the answer: Low and inside won’t always beat high and outside. The occasional boom in growth stocks will result in short-run relative underperformance of small-cap-value funds. This underperformance can last for years, and there’s no guarantee that the historical small-cap-value effect is going to last forever. Momentum was once thought to be a factor that could beat the market. That was until institutional investors capitalized on it and made it go away. Free lunches tend to get eaten.
So an adviser may swing at a few less attractive pitches, just to make sure a client’s portfolio won’t do much worse than his or her neighbor’s during a good year for growth stocks. Advisers might bet instead that small and value will continue to outperform, but they may find that funds that beat their benchmarks are easier to sell to a client, even if they aren’t the best funds. That is true particularly if the funds specialize in sexy growth sectors that seem like the next big thing. It’s hard to sell boring.
It’s worth revisiting the best explanation for the persistence of the value premium. Growth stocks tend to be less profitable than value stocks. Some of them might not earn any profit at all. Who is most likely to buy a growth stock? Optimists.
Growth stocks tend to underperform due to a combination of optimism and limits to arbitrage. Who’s buying Twitter? Investors who believe it will expand and find a way to derive an income stream from tweets. Who’s not buying Twitter? The skeptics who wonder how the company is ever going to harvest cash from a platform for transmitting Haiku communications.
While the optimists bid among themselves for the privilege of owning a share of Twitter, the pessimists shake their heads in disgust or short Twitter shares. But shorting Twitter is an expensive and dangerous game. Price bubbles have a way of lasting well beyond option-expiration dates, and many who have predicted a fall in stock prices have gone broke from bad timing.
This means that Twitter prices are free to float upward into growth territory, dragging down returns for investors who hook their wagon to a growth fund. This story isn’t going away. (How are those Tesla shorts working out?)
Value, then, is persistent, at least on a theoretical basis. It has persisted long after its identification decades ago in finance literature. Value outperforms in the U.S. and internationally. A long-run investor can feel pretty confident that he or she will get a portfolio boost from selecting value funds over growth. So the style box is useful as a way to identify how much a fund leans toward value as a manger attempts to capture a value premium or avoid funds that will drag down performance over time.
Costs and incentives
This brings us to the second question – why wouldn’t a fund manager lean toward small-cap-value within his or her own style box? The answer is all about incentives.
What are the costs of moving too far away from the benchmark, and what are the benefits? The cost is known as benchmarking risk. Every time I select a stock that moves my overall allocation away from my style benchmark, there is a greater chance that my fund will either do worse or better than the benchmark. There’s always a certain amount of randomness to stock performance. Even stocks that are undervalued can get trounced by overvalued stocks in any given year.
As the style-box-alpha graph shows, moving low and inside doesn’t always work within a style box. A fund manager who shifted away from the benchmark to be clever may now be selling used cars. That’s because mutual-fund investors are most sensitive to two types of fund returns – really good ones and really bad ones. This stems from what’s known as the investor-attention hypothesis: Most fund investors don’t pay much attention to their portfolio until it does something extreme.
A good strategy for a small fund is to try to beat the benchmark to gain investor attention and attract assets. Some funds will succeed and grow larger, and others will fail. Once a fund has grown by attracting investor dollars, incentives change. The goal now becomes keeping the investor dollars. And avoiding a really bad year is a good way to make sure investors stay put.
This leads to closet indexing. It has been estimated that over one-third of actively managed U.S. mutual fund assets are held in funds that hug their benchmark so closely that they are essentially very expensive passive funds. A fund manager may have an incentive to select a few attractive securities to beat the benchmark by a small margin, but not enough to risk losing his or her bonus. Like any good employee, fund managers try not to think too far outside the box.
Conclusion
Selecting a fund without a style box is like swinging at a pitch you can’t see. Morningstar doesn’t ask fund managers which box they’re in – they categorize funds within the box based on how the fund invests. If you’re investing in mid-cap value stocks, you won’t be a large-cap-growth manager no matter what it says on your business card. This takes away the incentive to cheat the style box system. The box is like a strike zone, and Morningstar is merely the umpire. You get to choose which pitches you want to swing at. What do you think Ted would do?
Michael Finke is a professor and director or retirement planning and living in the personal financial planning department at Texas Tech University in Lubbock, Texas. His students Tao Guo and Jimmy Cheng provided research assistance for this article.
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